SUMMARY: Once you’re ready to start investing, the next step is deciding where. This blog covers the topic of asset allocation and investment options to consider as you build your portfolio.
You’ve decided to take the plunge and put some of your hard-earned money into the market. But where? The options can seem endless and the rewards uncertain. An essential part of successful investing is asset allocation—a strategy that distributes your money across multiple types of investment vehicles and takes into account your goals and tolerance for risk.
The three most commonly used classes of assets—stocks (or equities), bonds and cash—each have unique properties that provide different levels of risk and reward. They tend to move independently in the market, which usually means when one is down, another is up. This reduces your overall risk and provides peace of mind that your portfolio is on a steady path.
Below, we detail these asset allocation options and tips on how to balance them to achieve your Goldilocks portfolio mix.
A company that finds itself in need of cash may opt to sell shares to investors, who then own a piece of the organization. The more shares an investor has, the larger their influence on the company’s operations will be.
Stocks are known for a high level of short-term risk but also potentially offer high rates of return over time. Some estimate that large-company stocks lose money one out of every three years on average. This can be a significant stress test for your risk tolerance, but the general consensus is that investors who keep a firm grip on the wheel and ride out the storm reap the rewards of high returns.
Stocks generally come in two distinct flavors:
Common stocks: If your portfolio has stocks, chances are they’re common stocks, which make up the vast majority of what companies issue. They give you voting rights and a claim on a portion of company profits (also known as dividends). Returns can be high, but the risk can be substantial, up to and including losing the whole nut should the company go down.
Preferred stocks: These differ from common stocks in that you typically have a guaranteed fixed dividend waiting for you in perpetuity. You will also be further up the food chain to be reimbursed should the organization face liquidation. The downside is that you likely won’t have voting rights.
A bond is a loan of sorts that you give to a governmental organization or corporation with a set interest rate and expiration date. Eventually, the issuer pays back the principal with interest. If you want to ditch the bond sooner, you can sell it on the open market. Bonds are generally deemed safer short-term investments but are less attractive for long-term growth.
There are three basic categories of bonds:
Short term (fewer than five years): Your money is pretty safe here, but it won’t gather many friends. If you need your investment back within three years, this option is ideal. Performance often depends on Federal Reserve policy.
Intermediate term (5-10 years): Most bonds fall into this bucket and become more popular in times of uncertain interest rates. Better rates than short term, less risk than long term.
Long term (more than 10 years): Your money hunkers down for the long haul in these bonds, which can bring great rewards but also put a target on your back for interest rate fluctuations. However the market goes, so go your long-term bonds.
Liquid assets are by far the safest investments but provide the weakest return of all your asset options. Options include money market funds, savings deposits, Treasury bills, certificates of deposit (CDs), and more. Your investments are largely guaranteed by the U.S. government, but inflation risk can be a concern, as it may rise faster than your rate of return.
Find the right mix
Every investor is unique and comes to the table with their own set of desires and resources. Your ideal blend of assets will largely depend on your current and future financial needs, pitted against your appetite for risk.
If your old Honda bit the dust last year and you have your eye on a shiny new Prius, a more conservative blend of short-term bonds, cash and CDs might do the trick. If your focus is on a worry-free retirement, time is your friend, and stocks are where you want to put down roots.
A balanced diet
A healthy portfolio is much like a healthy diet—you need the proper mix of fats, proteins, carbs and roughage to keep your body humming along smoothly. Likewise, your investment assets need a fortifying blend of stocks, bonds and cash to produce healthy returns. A wealth advisor may be a useful ally on this journey, and the checklist below may be helpful in finding one who suits your needs.