Asset Allocation: A Beginner’s Guide
Michael LeBoeuf once famously said the most important key to successful investing can be summed up in just two words: asset allocation.
For a young investor just starting out in the stock market, asset allocation is a critical first step that can make or break your overall strategy.
If you want to get started on the right foot, it’s important to build a strong asset allocation strategy and understand the different asset classes available to you. But what exactly does asset allocation mean? Let’s take a closer look.
What Is Asset Allocation?
Suppose you have a lump sum of $200,000 you want to start investing. Your goal should be to stretch your money as far as possible so that you can maximize your earning potential while reducing risk.
Asset allocation is an investment strategy that involves dividing an investment portfolio into different categories. You might pour money into mutual funds, ETFs, large-cap individual stocks, small-cap individual stocks, emerging markets, precious metals, money market funds, and other various asset classes.
When financial advisors mention diversification, this is what they are referring to: putting your money into all kinds of different investments instead of dumping it all in one place.
The Benefits of Asset Allocation
Here are some of the top reasons you need an asset allocation strategy as you pursue your investment objectives.
Protect Yourself from Volatility
Fluctuations are very common in the stock market. Prices constantly rise and fall, exposing investors to a great deal of turbulence. Asset allocation lets you spread money around to reduce risk and prevent you from winding up with 90% of your funds in a company like Enron.
Plan Long-Term Investments
Retirement will be here sooner than you expect. You’re in your prime earning years, which means it’s vital to start putting money aside so that it can grow. A sound asset allocation strategy lets you factor retirement into your long-term investment strategy, ensuring that you take care of your future self and achieve your investment goals.
One of the hardest parts about investing is maintaining discipline. An asset allocation strategy prevents you from going overboard in any one particular area, ensuring you cover all your bases, including short-term, medium-term, and long-term objectives.
How to Achieve Diversified Asset Allocation
To diversify your portfolio, start by breaking down investments into broad asset categories called asset classes. Here are the main asset classes you can build your portfolio around.
Equity Accounts (25%)
Equity refers to what’s paid by the owners or shareholders of a publicly traded company after an IPO and ongoing business operations, and all liabilities have been paid.
Young investors are generally advised to invest more heavily in this asset class than older investors because equity accounts can be highly volatile. However, they tend to produce the highest risk-return ratio of any investment, making them an excellent growth vehicle. If you’re just starting out as an investor, consider allocating 25% of your portfolio to equity investments.
Equity investments can be further broken down into the following subcategories.
Common stock, or equity, represents an ownership stake in a corporation. If you own common stock, you can vote on company policies and have a say when electing the board of directors. The more stock you own, the more ownership you have. When someone talks about “buying stocks”, they’re typically referring to common stock.
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Preferred stock is a type of ownership stake that does not come with voting rights. However, preferred stock owners have more rights than common stock owners when it comes to liquidation events; they’re in line to get paid back first.
Retained earnings means the net income that’s left over after a business has paid dividends to shareholders. This money can either be paid out to shareholders or reinvested in the company to drive growth or pay off future expenses.
Treasury stock is a stock that a company has bought back from the stock market. By decreasing the number of total shares outstanding, companies give existing investors more equity in the organization.
Fixed-Income Securities (20%)
Fixed-income securities are loans that produce fixed and predictable income to lenders at the maturity or expiration date of the agreement.
This asset class typically has less risk than equity investments. At the same time, their predictable nature caps growth. As you start investing, consider allocating 20% of your portfolio to fixed-income securities.
A bond is a debt instrument an investor makes with a loan issuer, wherein the issuer agrees to pay the principal back with interest at a fixed date. For example, savings bonds are issued by the U.S. Treasury and considered a safe investment because they are backed by the U.S. government.
Certificate of Deposit (CD)
A CD is a type of holding account offered by a bank where the investor agrees to lock their money into a fixed rate for a period of time. Like bonds, CDs provide expected returns.
One of the downsides to CDs is that you could face stiff penalties if you choose to access your money before the end of the term. That being the case, you need to make sure you are comfortable with the terms of the agreement before putting any money into this asset class.
When investing, it’s critical to have quick and easy access to capital when you need it. The last thing you want to do is tie up all your money. Otherwise, you won’t be able to pay your bills or jump on new investment opportunities when they arise.
Cash equivalents are flexible accounts that can be accessed with little to no hassle. You should put roughly 25% of your holdings in cash or cash equivalents.
Keep a small amount of cash on hand in a checking account, and use it at retail locations, restaurants, and with online merchants.
Coins and Paper Money
Buy a safe and keep a few hundred dollars locked up in your house so that you have cash on hand at all times. This is important for an emergency situation or if you get caught in a pinch and can’t make it to a bank.
Take the rest of your cash reserves and put it into a high-yield savings account (HYSA) or traditional savings account for safekeeping. Just make sure to shop around for the best possible interest rate to maximize your returns.
Keep in mind that savings accounts restrict how many transactions you are allowed to make in a monthly billing cycle. Don’t treat a savings account like a checking account or you’ll be penalized.
Real Estate (20%)
Investing in real estate is a great way to increase your net worth, save money on taxes, and diversify your portfolio.
You can invest in physical property, such as buying a house to rent or flip, or you can invest in a real estate investment trust (REIT), which is more affordable and has a lower barrier to entry. If possible, put 20% of your holdings into real estate.
Alternative Investments (10%)
Take your remaining assets and invest in goods and commodities. This may include art or antiques, gold, or even cryptocurrency with lasting value like bitcoin.
Just make sure that what you invest in appreciates in value. For example, a car depreciates in value as soon as you drive it off the lot. But an expensive or rare piece of art will maintain value as long as you protect it.
Tips for Allocating Assets
Determine Your Risk Profile
Spend some time thinking about your risk profile: the amount of risk you can absorb in the event of a downturn or failed investment.
As a young investor, you most likely will have a very high risk tolerance. As you get older, your ability to withstand risk will shrink because you will have less time and will likely be earning less income.
Build your profile in a way that allows for some level of risk but will shield you from volatility and protect your long-term savings.
Ask for Help
Don’t be afraid to work with a certified financial advisor when allocating assets to different asset categories. It might be your first time thinking about asset allocation, but it is certainly not their first rodeo. An advisor can work with you to help form an allocation strategy that works for your specific needs.
It can be difficult to ask for help. But a large portion of the world’s savviest investors do it regularly. An advisor can help teach you about finance and hold your hand when making specific investments amidst changing market conditions.
With the help of an advisor, you will have a much easier time with strategic asset allocation. If you don’t know what you’re doing, going it alone could be a recipe for disaster.
Revisit Your Portfolio from Time to Time
Over time, your situation is going to change, and the market will, too. You’re probably going to make more money, and you may meet someone and decide to get married or have children. Keep a close watch on your portfolio and make changes as your financial situation changes and market conditions shift.
For example, you may buy a multi-family house as an investment only to find it’s too much work and not generating the amount of rent you expected. If that’s the case, you may want to do a 1031 exchange and trade your property for an equal investment, a strategy that can potentially eliminate having to pay capital gains taxes.
Asset allocation portfolios are meant to change with time and undergo rebalancing periodically. Again, this is where it can pay to have the help of a financial advisor to walk you through the process.
Frequently Asked Questions
What is a target-date fund?
A target-date fund is a type of automated retirement investment fund designed to change as you get older. The fund is comprised of many different types of assets heavily weighted towards equities when you’re young.
As you get older and approach retirement age, the fund changes so that your holdings shift more toward cash and fixed-income securities. The idea is to shield you from volatility and protect your money so that you’re less likely to have an investment go belly-up with limited time to recoup the damage.
How are index funds classified?
Index funds are classified as equities, as they are collections of shares of many different companies. Index funds are more secure than stocks but they still carry a fair amount of risk. This is a passive type of investment, meaning it’s designed to try and track specific markets instead of trying to beat them.
What is a time horizon?
A time horizon refers to the amount of time you hold an investment until the point you need the funds.
When investing, you can have multiple time horizons. For example, you may decide to take $5,000 and put it in the stock market when you’re in high school or college with the intention of growing that money for a down payment on a house. In this case, your time horizon may be 10 or 15 years down the road, meaning you would adjust your investments accordingly to meet that need.
At the same time, you probably want to retire someday. As a result, you’ll have a separate time horizon for 30 to 40 years down the road. This type of planning requires retirement funds with tax benefits.
As you can see, time horizons can be short, medium, or long term.
Is cryptocurrency a good investment?
Every investor should at least be looking into cryptocurrency right now. It’s not for everyone, but savvy investors should at least know what it is and how it works.
In short, cryptocurrency is a digital, encrypted currency you can buy in a crypto exchange. Bitcoin is a leading cryptocurrency rapidly growing in popularity.
Cryptocurrency is extremely risky, as it’s highly volatile and largely unregulated. However, you could potentially strike it rich if you buy the right coins at the right time. Only invest in cryptocurrency if you are in a position to add risk to your overall portfolio.
What is a side hustle?
As you look at your assets, you may realize you’re not putting enough away for growth. If this is the case, you may want to consider starting a side hustle to bring in more money.
Just as it sounds, a side hustle is a job that produces a secondary source of income. For example, walking dogs and driving for Uber are both examples of side hustles.
The more you work, the more you’ll have to allocate into various savings and investment accounts.
The Bottom Line
If you’re going to be putting away money for growth, you need an investment strategy you’ll stick to. If you go in blindly, you’re bound to make mistakes along the way that could cost you significantly.
One of the best things you can do as an investor is to form an asset allocation strategy and focus on building a diversified portfolio with a mix of stock, real estate, cash investments, alternative investments, and fixed-income securities. Use tactical asset allocation and try to strategically spread your money around to reduce risk.
Remember: If you’re young, you may be in a position to take on higher risk. However, there is no shame in making conservative moves that generate consistent investment returns over time and help you achieve long-term financial goals.
At this point, it’s time to start devising an asset allocation plan that enables you to meet your long-term financial goals. Good luck!
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