Asset allocation is the process of dividing dollars in a long-term investment portfolio into different assets. The purpose: it’s an attempt to reduce risk without sacrificing return. But keep in mind that asset allocation does not eliminate the risk of experiencing investment losses.
Determining proper asset allocation depends on lots of factors. Two of the most important are the time horizon and long-term goals of a portfolio. But it doesn’t stop there. You also need to consider your age (which relates to the time horizon), current and future income sources, risk tolerance, and investment needs.
To help make sense of all this, consider the example in figure 1. Generally, younger investors can assume more risk in a portfolio. That’s because a young investor has time to ride the ups and the downs of the market. Now contrast a young investor with an older investor, who might need his or her investments to produce income in retirement, and may not have time to recover from down times in the market.
Asset Allocation: Starting with Stocks and Bonds
For simplicity, figure 1 uses stocks and bonds as the two assets among which a portfolio might be divided.
One potential benefit of focusing on stocks and bonds is that they allow an investor to weigh growth and risk versus income and safety. Simply put, over the long term, stocks historically supply a portfolio with growth. However, there are lots of ups and downs over long time horizons. The ups, and particularly the downs, are known as volatility, or risk. And remember, all investments involve risk, including loss of principal.
One way to help reduce the risk of stocks is by adding bonds to a portfolio. Stocks and bonds tend to move in opposite directions. It doesn’t happen all the time, but generally, when stocks fall, bonds rise. And when stocks rise, bonds fall. Importantly, bonds usually don’t rise or fall as much as stocks do on a percentage basis. This is because bonds are typically less risky than stocks.
One reason bonds fluctuate less than stocks is because bonds are designed to pay regular income. In fact, that income usually is a primary purpose of holding bonds in a portfolio; bonds’ price appreciation is a secondary consideration.
Thus, the income from bonds can be a stabilizing companion to stocks in a long-term portfolio.
Allocating Between Stocks and Bonds
Younger and middle-aged investors typically have a higher allocation to stocks rather than bonds because they are focused on growing a portfolio. Retirees and investors approaching retirement might consider higher allocations to bonds to reduce risk and provide income.
Still, even retirees typically have some allocation to stocks. Stocks’ growth could help a portfolio keep up with inflation. This means that even retirees should think about long-term investing; after all, they could live in retirement for 30 years or more.
To get a better sense of how investors with different goals and time horizons (among other factors) might allocate a portfolio between stocks and bonds, consider figure 2. This graphic compares the hypothetical performance of portfolios with different allocations among stocks and bonds over a 20-year period.
Figure 2 illustrates the hypothetical growth of a $1 investment in five different portfolios between January 1, 1996, and December 31, 2015. As illustrated, portfolios with a greater allocation to stocks generally produced higher returns than portfolios allocated more heavily to bonds. However, the higher returns of portfolios with large stock allocations are associated with higher volatility, or risk.
Think about where you are in your life and which ride might be easiest for you to stomach. This can help you determine a portfolio allocation that’s right for you. But remember, as time goes by, and you near retirement, you’ll need to change your allocation to reflect changing time horizons and risk tolerances.
In the next part of this series, we’ll discuss how to make these changes to a portfolio over time and other considerations relating to portfolio management.
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