In investing, as in life, risk and reward often travel hand in hand. When investing, you generally don’t want to avoid risk; instead, you need to manage it. Choosing the right asset allocation can help you balance risk and reward in your investment decisions.
Asset allocation means dividing your money among different asset classes such as stocks, mutual funds, bonds and cash equivalents (money market or other investments that can be cashed in quickly). Each asset class tends to react differently to market conditions, so gains in one asset class may help offset losses in another. That diversification can help reduce volatility (ups and downs) and manage risk. The main asset classes are:
- Stocks (as well as ETFs and mutual funds): these tend to offer the greatest expected returns over the long term, but they also have the greatest chance of ups and downs from year to year.
- Bonds and bond funds: these generally have less growth potential than stocks over the long term, and the changes in year-to-year value tend to be less dramatic compared to stocks.
- Cash equivalents: generally these have the lowest risk but historically have offered the lowest return over the long term.*
Asset allocation models often divide the asset classes as a percentage of your total investment portfolio. For example:
- An aggressive portfolio emphasizes stocks and may invest a small percentage in bonds and/or cash equivalents.
- A moderate portfolio is invested in a mix of stocks and bonds, with a small percentage in cash equivalents.
- A conservative portfolio focuses on low-risk, fixed income investments and cash equivalents, and may invest a small percentage in higher-risk stocks and bonds.
It’s possible to go into more detail in terms of diversifying your portfolio, including using more advanced strategic asset allocations with real estate or emerging market investments, for example. It’s also possible to keep it very simple, using only index funds and ‘target date’ funds. To choose an investment strategy that’s appropriate for you, you should consider:
Your Risk Tolerance
If you can handle dramatic short-term fluctuations in the market, an aggressive asset allocation may work for you. If you cringe at the idea of losing any money, then you may find peace of mind with a moderate or conservative risk profile.
Your Time Horizon
How many years do you have until you need the money? If your time frame is long, you have many years to ride out volatility in the stock market. If your time horizon is shorter, then a moderate or conservative approach may be a better fit. If it’s very short, a conservative strategy would probably make the most sense.
Your Investment Objectives
What’s your end investment goal, and how much money do you need to save? For instance, if you’re saving for something big (such as retirement planning), you may need an aggressive mix of investments with higher returns to get there. Keep in mind that a conservative portfolio comes with its own kind of risk: failing to keep up with inflation, which can erode your ability to reach your financial goals.
Your asset allocation, or the mix of asset classes you use, plays a large role in the annual returns your money earns. A study found that more than 90 percent of a portfolio's performance is determined by its asset allocation.**
A financial professional from Navy Federal Investment Services can help you create an asset allocation strategy that strikes the balance between risk and reward that’s right for you.
*Past performance is no guarantee of future results.
**Source: "Determinants of Portfolio Performance," Brinson, Hood and Beebower, Financial Analysts Journal, July/August 1991.
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