The federal government guarantees many investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do occur, but infrequently. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.
Stocks, bonds, and cash are the most common asset categories. These are the asset categories you would likely choose from when investing in a retirement savings program or a college savings plan. But other asset categories - including real estate, precious metals and other commodities, and private equity - also exist, and some investors may include these asset categories within a portfolio. Investments in these asset categories typically have category-specific risks. Before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. The practice of spreading money among different investments to reduce risk is known as diversification.
By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. In addition, asset allocation is important because it has a major impact on whether you will meet your financial goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio.
On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. Determining the appropriate asset allocation model for a financial goal is a complicated task. If you understand your time horizon and risk tolerance - and have some investing experience - you may feel comfortable creating your own asset allocation model.
There is no single asset allocation model that is right for every financial goal. With that in mind, you may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future.
But before you hire anyone to help you with these enormously important decisions, be sure to do a thorough check of his or her credentials and disciplinary history.
Many investors use asset allocation as a way to diversify their investments among asset categories. But other investors deliberately do not. For example, investing entirely in stock, in the case of a twenty-five year-old investing for retirement, or investing entirely in cash equivalents, in the case of a family saving for the down payment on a house, might be reasonable asset allocation strategies under certain circumstances.
But neither strategy attempts to reduce risk by holding different types of asset categories. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments. A diversified portfolio should be diversified at two levels: between asset categories and within asset categories.
The key is to identify investments in segments of each asset category that may perform differently under different market conditions. One way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. Not necessarily. While an easy-to-remember guideline can help take some of the complexity out of retirement planning , it may be time to revisit this particular one.
Over the past few decades, a lot has changed for the American investor. For one, the life expectancy here, as in many developed countries, has steadily risen. Compared to just 25 years earlier, Americans in lived almost three years longer.
At the same time, U. Treasury bonds are paying a fraction of what they once did. Some have modified the rule to minus your age — or even minus your age, for those with a higher tolerance for risk. Not surprisingly, many fund companies follow these revised guidelines — or even more aggressive ones — when putting together their own target-date funds.
For example, funds with a target date of are geared to investors who are currently around 50 as of Since women live nearly five years longer than men on average, they have higher costs in retirement than men and an incentive to be slightly more aggressive with their nest egg.
Basing one's stock allocation on age can be a useful tool for retirement planning by encouraging investors to slowly reduce risk over time. Centers for Disease Control and Prevention. Accessed March 15, Federal Reserve Bank of St. Rowe Price. Investment Returns: We use historical results of different major indices to calculate expected returns. Expected Returns Calculation: We use a Monte Carlo simulation of 10, portfolios to calculate expected returns. Barbara Friedberg is an author, teacher and expert in personal finance, specifically investing.
For nearly two decades she worked as an investment portfolio manager and chief financial officer for a real estate holding company. She is committed to investment and money education. Her writing has been featured in U. Once you've decided to start investing your money, you'll have to decide on an asset allocation that's appropriate for your goals, age and risk tolerance. And unless you invest in a Target Date Fund TDF that automatically adjusts that asset allocation, you'll have to rebalance your assets over the course of your investing time frame.
A financial advisor can help you manage your investment portfolio. To find a financial advisor near you, try our free online matching tool. When you buy shares in a company you're investing in stocks. This is also known as owning equities. Companies issue stocks as a way of raising money and spreading risk.
Some pay dividends to their shareholders. As a shareholder, you can make money through dividends, from selling the stock for more than you paid or from both. The value of shares fluctuates. You don't have to buy shares in individual companies to invest in stocks. You can also buy mutual funds, index funds or exchange-traded funds ETFs.
Individual stocks, mutual funds, index funds and ETFs all have something in common: they have the potential for relatively high returns, but also for relatively high risk. Buying stocks comes with what's called "equity exposure," the risk that the shares you own could fall in value or become worthless. This could be due to a problem with the specific company that issued the shares or it could be caused by a general stock market crash. If you want your money to grow substantially over time, you'll need at least some equity exposure.
How much you decide to allocate to stocks will depend on your goals, age and risk tolerance. Bonds are the foil to stocks. They're the slow-and-steady refuge when stocks aren't performing well. When you buy stocks you become a partial owner. With bonds, by contrast, you're a lender instead of an owner.
Companies and governments issue bonds to raise money. US Treasury bonds are generally considered a rock-solid investment because there's virtually no risk that you'll stop receiving interest or that you could lose your principal. While diversification through an asset allocation strategy is a useful technique that can help to manage overall portfolio risk and volatility, there is no certainty or assurance that a diversified portfolio will enhance overall return or outperform one that is not diversified.
CNBC, March 23, Investopedia, January 24, Forbes, April 8, Watch Again Next Video. Related Video.
Watch Again. How to Find Your Ideal Asset Allocation Achieving the right investment mix is a key strategy to ensure a balanced portfolio. Questions this article can help you answer: What is asset allocation? How can I determine the right asset allocation for me? How can I keep my asset allocation on track? What drives the decision? How can I minimize investment risk? Adapting to Any Market Reality.
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