Whether your retirement is years away or right around the corner, your investment portfolio (including asset allocation and risk management techniques) should be designed with your financial goals in mind. It needs to be forward-thinking enough to handle the whims of the market but flexible enough to make changes when necessary.
One of the most important concepts for any investor to understand is the relationship between risk management and asset allocation. Put simply, asset allocation describes the division of stocks, bonds, and cash that make up your investment portfolio. Although this concept is straightforward, it has one of the largest impacts on your financial future.
Each asset class has its own set of risks and rewards, depending on your time horizon and financial goals. You and your financial advisor may make adjustments to your portfolio over the years as your needs change.
- Stocks, also called equities, allow you to own a share of a publicly traded company. By investing in stocks, you have the potential for a higher return on your investment. But if the company has a bad year, or if the economy takes an unexpected turn, you may also lose money.
- Bonds, overall, have been a steadier source of fixed income. However, bonds are subject to interest rates and inflation risks, and their rate of return tends to be lower. This year, for example, has been a very bad year for bonds due to rising rates.
- Mutual funds and ETFs (exchange-traded funds) are pools of multiple companies in which you can invest. While many mutual funds have a mix of stocks and bonds, some specialize in one or the other. Mutual funds and ETFs offer less risk than investing directly in stocks, as diversifying your asset allocation tends to spread the risk around.
- Cash and cash equivalents give you flexibility for any unexpected emergencies that may arise. If your hot water heater dies, having funds on hand to take care of it without resorting to a credit card is helpful. However, your cash-on-hand cannot earn you money the way other investments might, so it needs to be a smaller portion of your overall asset allocation.
Finding A Balance
When it comes to managing your portfolio, asset allocation requires a more hands-on approach. “Setting it and forgetting it” may sound appealing, but changes in your life and financial goals will require portfolio reviews to make sure your asset allocation still makes sense. Working with your financial advisor is a great way to make sure that your asset allocation reflects your goals, and they can help make adjustments to any changes that life throws your way.