If you’re like most people, you don’t know all of the ins and outs of how investments work. You have an understanding, but the finer details are still a little unclear. Fortunately, that’s not a problem. There’s no need to dive into how it all works and learn an entirely new trade. What you do need to know, is how asset allocation models work. This will allow you to pick the right investments that fit your goals.
Table of Contents
Determining risk tolerance
Finding the right asset allocation model for you starts with understanding just how much risk you want to take on. Two categories make up that risk: time horizon and risk tolerance.
Time horizon – Simply put, how long will it be before you need the money you’re investing? Socking away money for a new car in five years will require you to invest more safely than putting away for retirement 20 or 30 years from now. Longer time horizons mean more opportunity to recover from a market downturn.
Risk tolerance – Your time horizon determines a good portion of your risk, but how much risk you actually feel comfortable taking determines the rest. Investing without emotional attachment is best, but we are emotional beings.
Understanding risk and reward
Generally speaking the more risk you take, the greater the potential reward. So investing heavily in startup companies has the potential for a huge return on your investment. It also carries the big risk that they may fail.
When you look at asset allocation models, you will see that a portfolio that is allocated toward equities instead of bonds. But if you’re very risk-averse, a portfolio of nothing but bonds likely still isn’t in your best interest since history shows that you will take the same risk for a lower return.
Asset allocation models can be broken down into as many categories as you would like, but most often they are divided into five based on how much risk you want to take.
Very conservative
The very conservative allocation is for those who no longer want to grow their wealth. Instead, their goal is the preservation of wealth. For those who are about to retire, or retired, a very conservative allocation will help to reduce their risk of losing money during a recession. Often these models are 90 percent bonds or more.
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Conservative
A conservative asset allocation model takes on a little more risk. The goal here is to preserve most of the wealth, but take some risk to capture gains before the money is needed. For investors that are approaching retirement, the conservative allocation helps to minimize their risk. A conservative allocation is often 80 percent bonds and 20 percent stocks.
Moderate
A big bulk of investors will fall into the moderate allocation. Here they take some risk in order to continue receiving a rate of return that will allow their portfolios to grow. But they balance that out with bonds to offset any potential losses during a market downturn. Those in the middle of their careers are best served with moderate asset allocation models made up of 40-60 percent bonds and 40-60 percent stocks.
Aggressive
If you have a long time horizon (20 or more years) an aggressive portfolio is probably right for you. There is plenty of time to recover from market downturns, and the risk taken now should provide a considerable rate of return to see lots of growth in the early part of your career. Most aggressive portfolios are about 20 percent bonds and 80 percent stocks.
Very aggressive
When you’re just starting your career, or you have a considerably long time horizon before you need to take a withdrawal, the very aggressive portfolio is used. This allocation is designed to provide big growth now so that you have a substantial base to draw on later. While a recession can wipe out a lot of the value, the long time horizon means you can recover without worries. Most of these portfolios are made up of at least 90 percent stocks, and often 100 percent stocks.
Which of the asset allocation models is right for you?
Asset allocation models can seem intimidating, but really it’s just allocating your dollars to the right places so that you take the risk you’re willing to take. If you’re working with a financial advisor, they should be helping you to re-evaluate your risk on a regular basis. This will ensure your portfolio is invested the way you want. Those meetings can be further apart at the early part of your career. But as you approach retirement they get closer together.
If you manage your own investments, there are many different programs that you can use to determine what risk you’re taking so you can rebalance as needed. You simply plug in the funds you have and their amounts, and the software does the work for you.
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Scott Sery
Scott Sery is a native to Billings, Montana. Within an hour in nearly any direction he can be found fishing, hunting, backpacking, caving, and rock or ice climbing. With an extensive knowledge of the finance and insurance world, Scott loves to write personal finance articles. When not talking money, he enjoys passing on his knowledge of the back country, or how to live sustainably. You can learn more about Scott on his website Sery Content Development
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If you are a moderate-risk investor, it's best to start with a 60-30-10 or 70-20-10 allocation. Those of you who have a 60-40 allocation can also add a touch of gold to their portfolios for better diversification. If you are conservative, then 50-40-10 or 50-30-20 is a good way to start off on your investment journey.
All About Asset Allocation offers advice that is both prudent and practical–keep it simple, diversify, and, above all, keep your expenses low–from an author who both knows how vital asset allocation is to investment success and, most important, works with real people.
Asset allocation involves dividing your investments among different assets, such as stocks, bonds, and cash. The asset allocation decision is a personal one. The allocation that works best for you changes at different times in your life, depending on how long you have to invest and your ability to tolerate risk.
For years, a commonly cited rule of thumb has helped simplify asset allocation. According to this principle, individuals should hold a percentage of stocks equal to 100 minus their age. So, for a typical 60-year-old, 40% of the portfolio should be equities.
The Rule of 100 determines the percentage of stocks you should hold by subtracting your age from 100. If you are 60, for example, the Rule of 100 advises holding 40% of your portfolio in stocks. The Rule of 110 evolved from the Rule of 100 because people are generally living longer.
The 4% rule entails withdrawing up to 4% of your retirement in the first year, and subsequently withdrawing based on inflation. Some risks of the 4% rule include whims of the market, life expectancy, and changing tax rates. The rule may not hold up today, and other withdrawal strategies may work better for your needs.
There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification. The most common forms of asset allocation are: strategic, dynamic, tactical, and core-satellite.
Asset allocation refers to distributing or allocating your money across multiple asset classes, such as equity, fixed income, debt, cash, and others. The primary purpose of asset allocation is to reduce the risk associated with your investment.
The correct answer is C. Lee invests his money in the most popular industries he's aware of. This is a common investment mistake known as herd mentality. When investors blindly follow the crowd and invest in popular industries without doing proper research, they may end up making poor investment decisions.
Cash is the most liquid asset possible as it is already in the form of money. This includes physical cash, savings account balances, and checking account balances.
Real estate investment has long been a cornerstone of financial success, with approximately 90% of millionaires attributing their wealth in part to real estate holdings. In this article, we delve into the reasons why real estate is a preferred vehicle for creating millionaires and how you can leverage its potential.
Your ideal asset allocation is the mix of investments, from most aggressive to safest, that will earn the total return over time that you need. The mix includes stocks, bonds, and cash or money market securities. The percentage of your portfolio you devote to each depends on your time frame and your tolerance for risk.
The 30% exposure to bonds buffers the risk of 70% equity exposure to some extent, besides providing stable returns. While asset allocation is generally governed by various factors including demographics and economics, the 70/30 rule may serve as a good starting point for most investors.
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