Asset allocation and risk management: what you need to know
It’s a fancy term for managing risk in your financial investments. It describes the process of using the 3 main asset classes—stocks, bonds and cash—in your portfolio.
When you hold a mix of investments, you can get a decently diversified portfolio. Deciding how much of your portfolio to invest in each asset class is called asset allocation.
Asset allocation is based on the principle that these different types of assets perform differently in certain market and economic conditions.
It’s important to understand asset allocation as it’s one of the cornerstones of retirement planning.
What’s an appropriate asset allocation?
The answer depends on your age, goals and objectives, and your appetite for risk. There’s no correct asset allocation blueprint for any particular investor … and no blueprint on how that mix should change as you age.
Adapting to risk as you grow older
If you have many years of employment ahead of you, you may want to consider an aggressive investment strategy that offers higher potential returns. Your asset allocation might be 85% stocks and 15% bonds and cash.
As you get closer to retirement, your exposure to higher risk assets, such as stocks, should probably decline. Your asset allocation could be 55% stocks and 45% bonds and cash.
You may be wondering why you wouldn’t just exit the stock market when you near retirement. The answer is most people should probably keep a small part of their investments growing, especially as life expectancies increase to 90 and beyond.
Investors grappling with lower interest rates have to take bigger risks if they want to equal returns of two decades ago.
In 1995, an investor could expect a 7.5% return by investing 100% of their investable assets into bonds.
And the standard deviation of those investments is 6.0%. Based on the assets that you own you could lose up to 12.88%.
Fast-forward 2 decades to today.
That same investor would need to invest in a number of different types of investments, including bonds, stocks and real estate, to get the same return. Their portfolio could return 7.5% annually, yet the maximum amount it could go up or down is a whopping 39.99% (Based on the assets that you own).
Do NOT just set it and forget it
Over time, market performance will alter the values of your different asset classes. If equities perform strongly during the year, you will likely have too much money invested in this asset category.
It’s a good idea to rebalance your portfolio to bring it back in line with your target allocation. Be sure to review your investment strategy at least annually or whenever your needs change.