Understanding Asset Allocation Strategy
Every investor wants to make money in both bull and bear markets. While it isn't possible to predict market dips, you can protect your portfolio in the event that one happens.
By making sure you have the proper exposure through asset and stock investment diversification, you can mitigate risk and take advantage of different market environments.
Risk/ Reward Trade-off
The biggest factor in shaping your investment portfolio is the amount of risk you can tolerate. Investors seeking the highest returns possible must take maximum risk. Such a portfolio might consist primarily of common stocks and their financial derivatives. An investor would expect a return much higher than the S&P 500 during bull markets to compensate for the substantial drops that may occur during bear markets.
Conservative investors typically seek to reduce risk by relying more heavily on fixed income assets that generate returns. Such a portfolio will gain less money when the market is rising and lose less money when the market is falling. Serious investors learn to accept the risk/reward trade-off and construct their portfolios accordingly.
How your portfolio performs will be based on the percentage of stocks, bonds, cash, and other assets that comprise it. Stocks and bonds are perfect for asset allocation as they tend to move in opposite directions in bull and bear markets.
Bonds do well when investors are fearful of risk and look for a safe haven to store their assets. Holding bonds can mitigate losses in a down market, and very conservative investors will hold a higher percentage of bonds to stocks.
Stocks, on the other hand, do best when investor appetite is high and money pours into the market for equities. More aggressive investors will hold a higher percentage of stocks to bonds. By creating an investment portfolio with a mix of stocks and bonds, an investor can ensure that one aspect of their portfolio will make money in any market.
Asset allocation is one form of diversification, but investors may also choose to diversify by investing in a range of industrial sectors. In fact, some investors may not want to diversify at all with asset allocation.
If they're young, for example, and have many years to ride out market ups and downs, it may be more prudent to invest in 100% stocks and realize maximum market returns. To diversify such a portfolio, the investor would want to hold stocks from different companies and across different sectors.
Mutual funds allow investors to hold stock in multiple companies without having to purchase each individual company's stock. They are commonly used to diversify a portfolio and can hold multiple asset types across different sectors or focus within one. The world of mutual funds is vast, and if not overwhelmed by the offerings, investors can find many mutual funds to fit their risk and diversification needs.
Years to Invest
Investors should only dabble in the stock and bond markets if they are willing to hold their investments for a number of years. Those who have a long time horizon can allocate a larger percentage of their portfolios to stocks since they can better tolerate market swings. Long term investors may expect the greatest market returns. Short term investors are better suited to purchase bonds and certificates of deposits. These are much safer assets and will probably not expose the investment to loss during a bear market.
Structure your portfolio in a way that reflects how much risk you can tolerate, your time horizon, and your investment goal, and then diversify accordingly. You may want to revisit it on a regular basis to address any changes in your situation or needs.
That said, the best performing portfolios are typically ones where assets are held long-term, and decisions aren't colored by emotion. Engineer a solid investment plan; re-evaluate periodically, but do your best to stick with what you started to reach your long term financial goals.
Mark Riddix is the founder of New Horizons Financial Management, an investment management company. Mark also contributes investing and personal finance content to Money Crashers, which is ranked as one of the top personal finance blogs. He writes a weekly column for Benzinga.
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