A chocolate cake. Pasta. A pancake. They are all very different but they generally involve flour, eggs, and maybe a liquid. Depending on how much of each ingredient you use, you can get very different results. The same applies to your investments. Balancing a portfolio means a combination of different types of investments through a pattern that suits you.
Get the right mix
The combination of investments you choose may be as important as your specific investments. The mix of different asset classes such as equities, bonds and cash, accounts for most of the ups and downs of a portfolio's return.
There is another reason to think about the mix of investments in your portfolio. Each type of investment has particular strengths and weaknesses that make it possible to play a special role in your overall investment strategy. Some investments may be chosen for their growth potential. Others can provide regular income. Still others may offer security, or simply serve as a temporary place to park your money. And some investments, even try to fill more than one role. Because you probably have more needs and desires, you need a combination of investment types.
Balancing how much of each you should include is one of your main tasks as an investor. This balance between growth, income and security is called your asset allocation. It does not guarantee a profit or insure against a loss, but it helps you manage the level and type of risks you face.
Balancing risk and return
Ideally you should strive for a comprehensive mix of investments that minimize the risk you take in trying to achieve a targeted return. That often means balancing to more conservative investments to other, which is designed to provide higher returns but also involves greater risk. For instance, let's say you want to get a 7.5% return on your money. Your financial professional says that a history stock market returns averaged around 10% annually, and bonds around 5%. One way to attempt to reach your 7,5% return would be by choosing a 50-50 mix of stocks and bonds. It can not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there is no guarantee that either shares or bonds will perform as they have in the past. But asset allocation gives you a place to start.
Someone living on a fixed income, whose priority is to have a regular flow of money coming in, will probably have a much different asset allocation than a young, affluent working professionals who give priority to saving for a retirement that is 30 years away. Many publications feature model investment portfolios to recommend generic asset allocations are based on an investor ages. These can help jump-start your thinking about how you divide your investments. But because they are based on averages and hypothetical situations, they should not be considered final. Your asset allocation is-or should-just as unique as you are. Even if two people are the same age and have the same income, they may have very different needs and goals. You should make sure your asset allocation tailored to your individual circumstances.
Many ways to diversify
When financial professionals refer to asset allocation, they are usually talking about broad classes: equities, bonds and cash. But there are others that can also be used to supplement the major asset classes when you have those basics. They include real estate and alternative investments like hedge funds, private equity, metals or collectibles. Because their returns are not necessarily correlate closely with the returns from major asset classes, they can provide further diversification and balance in a portfolio.
Even within an asset class, consider how your assets are distributed. For example, if you are investing in shares, you can assign a specific amount to large-cap equities and a different percentage of stocks of smaller firms. Or you can assign based on geography, put some money into U.S.
Asset Allocation Strategies
There are different approaches to calculating the asset allocation that makes the most sense for you.
The most popular approach is to look at what you invest and how long you have to reach each goal. These goals will be balanced against your need for money to live on. The more secure your immediate income and the longer you have to reach your investment goals, the more aggressive you may be able to invest for them. Your asset allocation may have a higher percentage of stocks than either bonds or cash, for example. Or you may be in the opposite situation. If you are stretched financially and would have to leverage your investment in an emergency, you need to balance that fact against your long term goals. In addition to establishing an emergency fund, you have to invest more conservatively than you would otherwise.
Some investors believe the move their assets between asset classes based on the types of investments they expect will perform well or poorly in the short term. But this approach, called "market timing", is extremely difficult even for experienced investors. If you're determined to try this, you should probably get some expert advice and realize that nobody really knows how the markets are heading.
Some people try to match market returns with a global "nuclear" strategy for most of their portfolio. Then insert a small portion of highly-targeted investments can behave very differently than in the core and provide greater overall diversification. These often asset classes that an investor thinks could benefit from more active management.
Just as you allocate your assets in a single portfolio, you can allocate assets to a specific target. For example, you have an asset allocation for retirement savings and another for college tuition bills. A retired professional with one conservative portfolio can still be comfortable investing more aggressively with money intended to be a grandson heritage. Someone who has taken the risk of starting a business can decide to be more conservative with his or her personal portfolio.
Things to ponder
* Do not forget about the impact of inflation on your savings. As time passes, your money probably buy smaller and smaller unless your portfolio at least keeps pace with inflation. Even if you think of yourself as a conservative investor should your asset allocation to take long-term inflation into account.
* Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested keeps you awake worrying at night, you may need to rethink your investment goals and whether the strategy you are pursuing is worth the lost sleep.
* Your tax status may affect your asset allocation, even if your decisions should not be based solely on tax issues.
Even if your asset allocation was the right thing for you when you select it, it can not be right for you now. It should be changed as your situation, and new ways of investing introduced. A piece of clothing you had 10 years ago may not fit now, you just may need to update your asset allocation, too.
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