Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing
Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How did you learn them? Through ordinary, real-life experiences that have nothing to do with the stock market.
For example, have you ever noticed that street vendors often sell seemingly unrelated products - such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never - and that’s the point. Street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. And when it’s sunny, the reverse is true. By selling both items - in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.
If that makes sense, you’ve got a great start on understanding asset allocation and diversification. This publication will cover those topics more fully and will also discuss the importance of rebalancing from time to time.
Let’s begin by looking at asset allocation.
Asset Allocation 101
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
Time Horizon
Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.
Risk Tolerance
Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
Risk versus Reward
When it comes to investing, risk and reward are inextricably entwined. You’ve probably heard the phrase “no pain, no gain” - those words come close to summing up the relationship between risk and reward. Don’t let anyone tell you otherwise. All investments involve some degree of risk. If you intend to purchase securities - such as stocks, bonds, or mutual funds - it’s important that you understand before you invest that you could lose some or all of your money.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.
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