Here's a common problem: You want to start investing but you're faced with tens, hundreds, or even thousands of options. Between mutual funds, exchange-traded funds (ETFs), and individual stocks, there seem to be as many choices as stars in the sky.
At this point, lots of people give up, procrastinate, or just pick investments randomly. But it shouldn't be this way. You can build your portfolio methodically just like many professionals do—starting with asset allocation.
It sounds very complicated and technical, right? But, it's a simple concept. Asset allocation refers to the way you spread your investing dollars across three major types of investments—stocks, bonds, and short-term investments (or cash)—based on your time frame, risk tolerance, and financial situation.
Studies have shown that the way you divvy up your money across these three investment types can have a tremendous influence over your long-term returns—and that's before you've even begun choosing mutual funds or stocks.
It starts with you.
But how do you know how much money to put toward stocks or bonds? It all starts with you. The basic things to think about include how long you plan to invest (known as your time horizon), your financial situation, and your tolerance for risk.
Risk tolerance is a squishier measure than your time and money situation. The more stocks you have in your investment mix, the more your account value may rise and fall. Risk tolerance asks you to consider how much stock market up-and-down you’re willing to put up with. Depending on the level of stock market exposure in your investment mix, you could be in for a very wild ride or a fairly sedate experience.
At the extremes, it's like comparing a high-tech roller coaster with a gentle kiddie roller coaster. For the chance to get higher returns over the long-term, investors have historically had to put up with bigger fluctuations in value over the short-term. The table illustrates just how wide the swings have been.
Stocks provide growth.
You may be thinking, "I'm afraid of heights and would prefer the kiddie coaster experience." There's just one problem with that: Stocks have historically provided higher returns than less volatile investments, and those returns may be necessary in order for you to meet your goals. And this is where your time frame comes in. Over the short term, the stock market is unpredictable, but over the long term, it has historically trended up.
If you have decades to stay invested, you are in the best position to take advantage of the long-term tendencies of the stock market. With time to ride out downturns, you may be able to benefit from potential appreciation in your investments and compounding as the years pass.
But you don't have to be 100% in stocks to benefit from the way the stock market has historically moved. Adding bonds and cash-like investments to an all-stock investment mix can have a stabilizing influence, cushioning some of the fluctuation due to volatility.
On the other hand, adding some stocks and bonds to a portfolio of stable, short-term cash investments could boost returns. Where you start simply depends on you and what you're trying to achieve.
Focus on time in the market.
Time makes all the difference. The chart above illustrates portfolios with varying degrees of stock market exposure and how they fared during their worst year and best year as well as their best and worst 30-year periods. Over a short period of time, the worst-case scenario would have been quite bad if you held a lot of stocks. But with an investment time horizon of 30 years, your worst-case scenario would have still been nearly as good as the best 30 years in the conservative allocation.
You simply don't know which outcome you're going to get. Even if you have nerves of steel and ice-water in your veins, it would still be a bad idea to invest all of your savings in stocks if you need your money in just one year. No one knows what the market will do; it could work out or you could end up losing half of your hard-earned savings simply because you needed cash and were forced to sell some of your stocks.
Being able to stick with your plan through the ups and downs of the market is vital because staying invested over many years is nearly always preferable to the alternative—letting time go by when you're not in the market.
Remember to diversify.
Diversification goes hand in hand with asset allocation. After you've decided on the broad strokes for your investment mix, it's time to fill in the blanks with some investments. While there are a lot of ways to do this, the main consideration is making sure you are diversified.
Diversification can reduce the overall risk in your portfolio, and could increase your expected return for that level of risk. For instance, if you invested all your money in just one company's stock, that would be very risky because the company could hit hard times or the entire industry could go through a rocky period, taking the company's stock down with it for a period of time.
Investing in many companies, in many types of industries and sectors, reduces the risks that come with putting all your eggs in one basket. Similarly, spreading your investing dollars among different types of bond issuers and bond maturities can provide diversification on the bond side of your investment mix.
A key concept in diversification is correlation. Investments that are perfectly correlated would rise or fall at exactly the same time. If all of your investments were rising and falling at the same time, you'd experience a lot of fluctuation in the value of your investments. If your investments are going up and down at different times, the investments that do well will offset the ones that do poorly. The end result for you is less volatility in your portfolio. Keep in mind that asset allocation and diversification influence the level of potential risk and return by degrees—diversification and asset allocation do not ensure a profit or guarantee against loss.
Commit to an ongoing balancing act.
Once you've set your asset allocation and investments, chances are, it will begin to change as some investments do well and overgrow the proportion of your portfolio that you allotted—especially if you are regularly contributing to the account. Other investments may shrink. Getting your asset allocation back on track is known as rebalancing. For example, let's say you set your mix to invest 50% of your money in the stock market and, over time, that percentage increased to 65% due to market growth. You may want to make changes to bring it back to your 50% target.
How frequently should you rebalance? It depends on what makes you comfortable, but generally you should check in periodically, whether annually or quarterly, and reset your allocation if it has strayed from your original plan. Investing can be confusing and intimidating, but it doesn’t have to be. With the roadmap provided by a basic asset allocation plan, you might find that planning your investments isn’t so complicated after all.
Take the next step
Watch this video to learn more about investing and managing risk.