Investing terms to know: Asset Allocation and Diversification
IF you have ever read or watched a beginning investors guide or talked to some relative at a party about investing you have most definitely heard the term “don’t put all of your eggs in one basket”. This happens to be one of the most ignored yet most important pieces of advice in the investing world.
So what are they saying when they tell you this? In basic terms, it means spread your money among different investments. This means different things to different people but in general it makes a lot of sense.
For example, lets look at real estate. When you buy an investment property you are put a bulk of money into one house, one one street, in one neighborhood, in one town, in one county, in one state, and in one country. This could be considered a highly concentrated investment because all of that money is invested in a house that is the focal point of the risk. At any point if any of those locations I mentioned experience an issue then your investment will suffer the consequences. For instance, lets say the town gets a new sheriff who thinks crime isn’t a big deal. Your investments value will drop because no one wants to rent in your crime filled town. Basically your eggs are in a very tall and unwieldy basket and if any of it starts to shift it will all come crashing to the floor.
To combat this issue you would need to buy multiple properties in many different locations. This is called diversification. By investing in different locations in different towns of different states you avoid having all of your investments being subject to so many risks at the same time.
This is typically too expensive for the average investor so that is why investors turn to stocks and bonds. These investments are much more accessible due to their lower entry costs. Another great benefit to these investments is the ease at which you can diversify your investments. The most common types of investments, or asset classes, are stocks, bonds, real estate, and cash. In most cases these assets classes do not behave the same way which provides the risk diversification investors need. All of them serve different purposes in your portfolio and even have underlying types of assets that provide greater diversification. For example, stocks are considered growth assets and with that asset class are different companies in different industries that are all exposed to different types of risk. Also these companies could be in different countries or use different currencies. There are endless possibilities for creating diversification in your asset allocation.
So how do you pick your own mix of investments that is right for you?
That is a loaded question. There have been countless studies giving rhyme and reason to determining perfect allocations individuals and institutions alike but realistically it comes down to a few things.
1. Your ability to handle risk or risk capacity. Most people even have a hard time answering this question because we all overestimate our abilities to handle risk. No questionnaire will help you discover this but a large drop in your portfolio will. If you can’t handle a drop of 5, 10, or even 15% in your portfolio then you’re most likely conservative and want a lower risk portfolio. If you can handle swings in your portfolio value of 50% then you could be considered an aggressive investor and be able to handle greater risk.
2. Your investing goal time horizon. Your risk should decrease if you need the investment money in a short amount of time but if your goal is something like retirement that is over 30 years away you can take on much more risk. This is because in the long term your portfolio has more time to recover and still hit your goal. If you only have a year then you will likely miss your mark if your investment value falls.
3. Required risk. This one is interesting. In order to achieve higher returns you will have to take greater risks. There’s no way around it. In some cases your investment goal will require you to take on a greater amount of risk to be achieved. Like in movies when the hero needs to make a crazy jump to a rooftop to catch the villain. If he doesn’t jump the bad guy gets away but if he does he saves the world. The risk is required to make the necessary return.
Next you need to figure out what mix of assets you need in your portfolio to match your risk capacity, time horizon, and required risk. Each of the common asset classes have characteristics that will help you determine what to add.
Stocks – Considered a higher risk or growth asset. Minimum of 5 years needed in most cases to see necessary returns.
Bonds – The goal is to preserve assets and provide income. Found between the risk spectrums of cash and stocks. Shorter time required for investing but still a long term investment.
Real estate – Mainly a income producing asset. Very long time horizon required.
Cash – short term use asset. Where you put your money if your goal is to be achieved within 1 year or less. Is naturally always losing value to inflation so don’t keep this stashed under your mattress.
Bonus!
Over time the percentage values of your investments will shift because they should not all be performing at the same rate. That is the whole point of asset allocation. After some time you will want to do a rebalance. This will sell some of your winners and buy more of the losers in your portfolio. Buying low and selling high. This will keep your portfolio in line with your necessary risk needs. Over time you will changes that occur in your life or you will get closer to your goal at which time you will need to rebalance. Investing is not a set-it-and-forget-it task. We must remain vigilant and watchful.
There are many calculators out there that will ask you questions to determine your risk tolerance but the best way to do this is to work with a professional. This person should spend enough time with you to understand your risk needs to help steer you to the best asset allocation. This is more art than science because you are a person and not a computer. Your risk needs to be considered on a personal and psychological level.
Here is how IF determines asset allocations by account.
1. First we need to determine the goal associated with the account. If this is an account you won’t look at for a while, say for retirement, then we can put more into risk assets. If you were using the account for current income then I would consider more to cash and bonds to preserve the capital and have it ready for distribution.
2. After determining the goal of the account I would need to know how many years of income you will need and the cash needed to cover those years. Cash will be necessary for any short term goals or expenses.
3. Another consideration here is the clients overall portfolio. This means we look at all of the other investments they have and see if there are any threats of concentration in a position or type of investment. For example, if a client has a large portion of their assets in real estate or apple stock then I will have to take that into consideration for the allocation in the account in question. This might also bring up a point to decrease that concentration if possible so we can create more diversification in the clients asset mix.
4. All while this is happening I am learning more about you as a person. Are you aware of the risks you’re already taking? Do you own only one stock? Is your cash under your mattress? Do you have a corporate job or do you have your own business? How do you handle risk in your personal like? Such as, did you used to sky dive a lot or do you like to take slow lane home. All of this matters.
5. After this process I will introduce a couple of options. We will make the decision together and make a commitment to the strategy for a certain period of time based on the goal time horizon. No investment has proven success overnight and so we must put a firm commitment on sticking to the strategy even if we hit turbulence right away. Commitment to a strategy is the cornerstone of success in investing.
6. Monitor and rebalance(infrequently) throughout the life of the commitment. In some cases we will need to reassess your goal because we are human and major life events happen often. If this occurs we can potentially mold the portfolio based on your needs but stick to the originally strategy.
To learn more about my process check out my investing page here.
Investing is as complicated as we are as people. But just like raising a child, there are always mishaps and short-term bumps along the way but we must think long-term and have faith that they will grow up to be good people. Think of your investments like your child and you will be ready to handle the bumps that are guaranteed to happen along the way.
If you need a local(or remote!) financial advisor in the Philadelphia or Charlotte areas IF is here to help. Just schedule a call with the button below and we can get started.
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