Investing Unit 2: Asset Allocation


Asset Allocation

In the final analysis, your overall investment return will be closely associated with the asset categories and allocations that you select. An investor’s group of investments, frequently called an investment portfolio, can be divided in numerous ways among stocks, bonds, and cash management options. You might choose a 20/40/40 portfolio . . .20% stocks, 40% bonds, and 40% cash options. Or . . . a 75/20/5 ratio . . . 75% stocks, 20% bonds, and 5% cash.

Figure 4. Asset Asset Allocation Options; Key: S=Stocks  B=Bonds  C=Cash Management

Figure 4. Asset Asset Allocation Options; Key: S=Stocks B=Bonds C=Cash Management

Several factors will impact the exact rate of return that you receive on your investment portfolio. Studies show that the most important one, asset allocation, will account for about 90% of your return. The selection of individual securities and market timing will account for the remaining 10% or so. The critical question, of course, is: “What is the ideal asset allocation for you?” Here are several factors to consider as you make this decision.

Your Ideal Asset Allocation will be Influenced by Your . . .

  • Investment Goals
  • Risk Tolerance
  • Time Horizon
  • Tax Situation
  • Time & Skill to Manage Portfolio

Your Investment Goals

Goals are specific things (e.g., buy a car) that people want to do with their money. As discussed in Unit 1, as people move through various life stages, their needs and financial goals change. Your selection of investments should relate closely to your financial goals; each goal will define the amount and liquidity of the money needed as well as the number of years available for the investment to grow.

Your Risk Tolerance

Risk tolerance is a person’s emotional and financial capacity to ride out the ups and downs of the investment market without panicking when the value of investments goes down. Risk tolerances vary widely. Some are associated with personality factors, while others are based on changing needs dictated by your stage in the life cycle. If you won’t sleep well at night when the principal value of your investment goes down, you should select saving and investment options with lower risk. On the other hand, it’s important to realize that investments which guarantee the safety of principal will not grow your money quickly and may not maintain purchasing power in times of inflation or over a long time span. In reality it’s necessary to take some risk just to maintain purchasing power. The question is: “What kind of risks are you willing to take?”

Your Time Horizon

As discussed earlier, time is a very important resource to investors. For example, young investors with a long time horizon may choose investments that exhibit wide price swings, knowing that time is available for fluctuations to average out. Families investing for a specific mid-life goal (e.g., funding a child’s education or purchasing a home) may choose a more moderate course which has opportunity for growth, but provides more safety for the principal. Individuals nearing retirement and those with the need to depend on investment income to cover daily expenses, may wish to select investments that lock in gains and provide a guaranteed income stream.

Your Tax Situation

The return on any investment is influenced by your federal, state, and local tax situation. Investment earnings may be:

  • Taxable – Taxes paid yearly on interest, dividends, and annual capital gain distributions from investments.
  • Tax-Deferred – Taxes on earnings are deferred until withdrawal. Tax-deferred earnings include contributions and returns associated with IRAs, 401(k)s, and other retirement saving plans (see Unit 7).
  • Tax-Exempt – Earnings are wholly or partly free from taxes. Roth IRAs and most municipal bonds are common examples. (Tax-exempt status may be different at the state and federal levels.)

Before selecting an investment, learn about its tax consequences for you. Remember, what counts is not what you make on an investment, but what you get to keep both now and in the long run.

Time and Skill to Manage Your Portfolio

Some investments require little or no time commitment or special knowledge. Others, such as rental property or a portfolio of high-risk individual stocks, may require constant monitoring and management. How much time are you willing and able to spend?

In a nutshell, the asset allocation which you select must be customized to your situation, needs, and temperament. Spend a few minutes completing the “What are Your Investment Preferences?” exercise to help you further clarify and summarize your investing preferences.