About Asset Allocation
You may not need to be an expert to manage your investment portfolio. Just showing initiative—as you’re doing to learn more about financial planning—is an important step. As you’ll see, certain investing strategies may help you weather market cycles and pursue your savings goals. Let’s take a look at how asset allocation, diversification, rebalancing and reallocating strategies can help.
Asset allocation is a fancy name for a simple strategy. It means spreading investments across different asset classes: stocks and mutual funds, fixed-income investments (such as bonds and bond funds), and cash equivalents (like money market funds). When you choose your asset allocation, you dedicate a certain share of your money to each of the asset categories.
A good asset allocation strategy depends on 3 major factors:
- Your investment goals. What are you saving for? How much money do you want to save?
- Your time horizon. When will you need the money? People who are within a few years of retirement, for example, may want to invest conservatively. That means less money in stocks and more in bonds and low-risk investments, such as certificates of deposit or Treasury bills. If you have decades until you need the money, you may want to invest aggressively, with more money in the stock market or more expert-level investments like real estate.
- Your risk tolerance. Investors who can ignore temporary market volatility might be able to tolerate the higher risk of stocks. If you’ll lose sleep during market dips, you may be happier with a lower level of risk even at the expense of some potential returns.
Of course, your strategy for portfolio management may change over time, based on your age and financial goals.
A Dive Into Diversification
Diversification takes the strategy of asset allocation one step further. With diversification, you buy different assets within a particular asset class. Why Diversify? It’s easy to see that putting your faith in just one investment means your entire portfolio is dependent on its ups and downs.
For example, suppose you buy 100 shares of XYZ Company at $10 a share, for a total of $1,000. XYZ Company invents a new gadget. Its stock rises to $30 a share. You’ve just tripled your money! What if, instead, another company comes up with a better gadget and your stock in XYZ Company drops to $5 a share? You’ve just lost half your money. Ouch.
On the other hand, if you spread that original $1,000 investment among a mix of stocks, then the share prices aren’t likely to all go up and down at the same time. In a diversified portfolio, you might not make as much as you could with one superstar stock, but you also might not lose as much as you could with one failing company. It’s all about seeking growth while spreading the risk.
Think of diversification as broadening your horizons, only with your money instead of your talents.
Diversification Adds Protection
Besides simply choosing different companies, other ways to diversify include the following:
- By market capitalization. Market capitalization is the total value of all shares of the company. You could choose among large-capitalization, mid-cap, small-cap and micro-cap stocks. Multi-trillion-dollar companies like Apple® and Microsoft® are examples of large-cap stocks.1 Generally, in the stock market, investing in large-caps is considered a conservative strategy. Small- and micro-cap stock investments are more aggressive, particularly for start-up operations, and mid-caps are a middle road.
- By geography. You could choose foreign stocks in addition to domestic (U.S.) stocks. Keep in mind that foreign investing involves extra risks, such as currency fluctuations, political developments and accounting standards that are different than in the U.S.
- By sector. Consider choosing companies among different industries, such as energy, transportation and health care.
Keep in mind that you don’t have to pick a bunch of individual stocks yourself to diversify. The easiest approach is to invest in index funds or exchange-traded funds (ETFs), which are baskets of many stocks you can buy all at once.
Here are a couple of ways to diversify bond holdings:
- By maturity. You could choose to hold anything from long-term (10- to 30-year terms) to short-term (generally, 1- to 3½-year terms) bonds. Longer-term bonds may pose more interest-rate risk (the chance that market interest rates may subsequently go up and the price of the bond goes down). Short-term bonds may pay less interest. Bond rates are largely dependent on the term plus the credit rating of the bond.
- By issuer. Choose from bonds issued by corporations, municipalities and the federal government. U.S. Treasury bonds are backed by the full faith and credit of the U.S. government and therefore are considered the least risky.
As with stock funds, you can diversify your fixed-income portfolio by buying bond funds rather than individual bonds.
Rules for Rebalancing & Reallocating
Rebalancing is a simple concept. It’s the process of adjusting an asset allocation that may be out of whack because one or more asset classes have had higher returns than others.
You may want to rebalance your portfolio once a year or whenever your asset allocation strays significantly from your investment objectives.
A slightly different approach is called reallocation. Rather than buy and sell to return to your original target, you buy and sell to create a new target asset allocation. For example, perhaps you’ve realized that, with an investment horizon of 30 or more years until retirement, you can afford to take more risk with your investments. Right now, your portfolio consists of 60 percent stocks, 30 percent bonds and 10 percent cash equivalents. Reallocation to a new, more aggressive asset allocation target would involve selling bonds and cash equivalents and buying more stocks.
Conversely, you may think your portfolio is too aggressive because you’re reaching a savings goal and want to focus on protecting your money. In that case, you’d sell stocks and buy more bonds and cash equivalents. The idea is to maintain an asset allocation that's appropriate for your goals, timeline and risk tolerance.
Applying Principles of Dollar-Cost Averaging
Dollar-cost averaging is an investment strategy that refers to making consistent investment in the same fund or stock at regular intervals. By investing this way, you don’t need to worry about “timing the market.” When you invest a set amount each month in your 401(k) or Thrift Savings plan (TSP), you’re using this principle, which helps your long-term investment strategy through periods of volatility and inflation.
Market Fluctuations and Economic Considerations
In the investing arena, change is constant. Markets fluctuate. Everything from corporate earnings reports to mergers to economic indicators has an impact. In the midst of market volatility, it may be difficult to look at your retirement plan or nest egg.
Inflation: An Increase in the Cost of Living
Inflation is the rise in consumer prices. Although deflation—a drop in overall prices—can also occur, it’s unusual. Here are some of the effects of inflation:
- The price of everyday items tends to be stable.
- Employees may see small or nonexistent raises.
- Prices increase, reducing purchasing power.
- Earnings may not keep up with the cost of living.
- Retirees on fixed incomes may lose buying power.
It’s important to understand how inflation affects saving for your retirement account and your overall financial situation. Even with low rates of inflation, you will need more money in the future to have the same buying power you do today.
1Navy Federal Financial Group, LLC (NFFG) is a licensed insurance agency. Non-deposit investments, brokerage, and advisory products are only sold through Navy Federal Investment Services LLC (NFIS), a member of FINRA/SIPC and an SEC-registered investment advisory firm. NFIS is a wholly owned subsidiary of NFFG. Insurance products are offered through NFFG and NFIS. These products are not NCUA/NCUSIF or otherwise federally insured, are not guaranteed or obligations of Navy Federal Credit Union (NFCU), are not offered, recommended, sanctioned, or encouraged by the federal government, and may involve investment risk, including possible loss of principal. Deposit products and related services are provided by NFCU. Financial Advisors are employees of NFFG, and they are employees and registered representatives of NFIS. NFIS and NFFG are affiliated companies under the common control of NFCU. Call 1-877-221-8108 for further information.
This content is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.