- First, think about how long you plan to stay invested, your financial needs, and how much risk—or changes in portfolio value—you could tolerate.
- Consider how much of your investment mix should be in different asset classes (such as stocks, bonds, and short-term investments) that offer the return potential needed to help you meet your goals with a level of risk you can live with.
- Finally, pick a diversified mix of investments.
Here's a common problem: You want to start investing but you're faced with tens, hundreds, or even thousands of options. It can be overwhelming.
But it shouldn't be this way. You can build your portfolio methodically just like many professionals do—starting with asset allocation.
Asset allocation refers to the way you spread your investing dollars across asset classes—such as stocks (US and foreign), bonds, and short-term investments (such as money market funds)—based on your time frame, risk tolerance, and financial situation. (Those 3 aren't the only asset classes—for example, real estate and commodities are generally considered distinct from the basic 3 listed here.)
To learn more about determining your risk tolerance and time horizon, read Viewpoints on Fidelity.com: 3 key factors to choosing investments
Studies have shown that the way you divvy up your money across multiple asset classes such as stocks, bonds, and short-term investments can have a tremendous influence over your long-term returns—and that’s before you’ve even begun choosing mutual funds or stocks.
If it seems like too much, you don't have to build your own investment mix to reach your goals. For many investors, it may be easier to turn to a target date fund for retirement goals or an asset allocation fund to handle the investment decisions. To learn more, read: Diversification through a single fund
Alternatively, you could consider a managed account for investment guidance and ongoing advice to help you stay on track. Read Viewpoints on Fidelity.com: 4 benefits of financial advice
Why stocks? Growth potential
Stocks have historically provided higher returns than less volatile asset classes, and those higher potential returns may be necessary in order for you to meet your goals. But keep in mind that there may be a lot of ups and downs and there is a generally higher risk of loss in stocks than in investments like bonds. 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 potential growth opportunities of the stock market. With time to ride out downturns, you may be able to benefit from potential appreciation in your investments as the years pass.
Why bonds? Diversification and income
Bonds can provide a steady stream of income by paying interest over a set period of time (as long as the issuer can keep making payments). There’s a spectrum of risk and return between lower-risk bonds and those that are more risky.
The credit risk of the bond issuer determines how much interest the bond may pay. Bonds issued by the US government pay a relatively low rate of interest but have the lowest possible risk of default. Corporate bonds typically pay a higher interest rate than Treasury securities of similar maturity. On corporate bonds, interest rates (yields) vary as a reflection of the creditworthiness of the bond issuer.
Because bonds have different risks and returns than stocks, owning a mix of stocks and bonds helps diversify your investment portfolio, and mitigate its overall volatility. Adding different types of investments to your mix with varying levels of risk and potential return can potentially help your investment mix weather different types of market environments and help smooth out the ups and downs of your overall portfolio.
It's important to understand that diversification and asset allocation do not ensure a profit or guarantee against loss—but they may help you reach your investment goals while taking on the least amount of risk required to do so.
Why short-term investments? Stability and diversification
For long-term goals, short-term investments are typically only a small portion of an overall investment mix. They generally pay a minimal rate of return but can offer stability and diversification.
Asset allocation and diversification
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 both across and within asset classes.
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.
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 your investments are going up and down at different times, the investments that do well may dampen the impact of the investments that exhibit poor performance.
To learn more, read Viewpoints on Fidelity.com: The guide to diversification
Commit to an ongoing balancing act
Asset allocation is not a set-and-forget-it exercises. You'll want to revisit it periodically, or if your goals, investment horizon or financial situation changes.
Another reason it's important to revisit your investment mix is to evaluate the need for rebalancing. Your investment mix may change over time as some investments do well and grow while others may shrink. Getting your asset allocation back on track is known as rebalancing.
To learn more, read Viewpoints on Fidelity.com: Give your portfolio a checkup
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.