Without risk comes no reward, but one can still be prudent on how much risk to take, AND when to get off and keep the house's money!
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Balancing a Retirement Portfolio with Asset Allocation
The combination of investments you choose is as important as the individual investments themselves. In fact, many experts argue that it's even more
important, since the mix of various types of investments accounts for most of the ups and downs of a portfolio's return. Each type of investment, or asset class, has strengths and weaknesses that let it play a specific role in your overall investing strategy.
Some investments, such as stocks, may be chosen for their growth potential. Other asset classes, such as bonds, may provide regular income.
Still others may offer relative stability or serve as a place to park money temporarily. And some investments may try to fill more than one role. Balancing how much of each asset class you should
include in your retirement portfolio is one of your most important tasks as an investor. That balance between growth, income, and safety/stability is called your
asset allocation. It can help you manage the level and type of risks you face.
Balancing risk and return Ideally, you should strive for an overall combination of
investments that take the least amount of risk in trying to achieve a targeted rate of return.
This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let's say you want to get a 7.5% return on your money. You've read that in the past, stock
market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your desired 7.5% return would be by choosing a 50-50 mix of stock and bond investments. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there's no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation
gives you a place to start. Someone who is close to retirement and about to
start relying on his or her savings for living expenses will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that's 30 years away.
The level of risk you are able to take is known as your "risk tolerance," and it's affected by factors such as how soon you'll be using your savings as well as your
emotional and financial ability to handle setbacks. Don't forget about the impact of inflation on your retirement savings. As time goes by, your money will probably buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you
think of yourself as a conservative investor, your asset allocation should take long-term inflation into account.
Many ways to diversify In addition to thinking about how to divide your assets
among stocks, bonds, and cash — the three basic asset classes — consider how your assets are allocated within an asset class. For example, for the stock portion of your portfolio, you could allocate a certain amount to a mutual fund that invests in large-cap stocks, and a different percentage to one that focuses on stocks of smaller companies. Or you might allocate based on geography, putting some money in U.S. stocks and some in those of companies overseas. Bond funds will vary based on the underlying bonds they hold, and are subject to the same inflation, interest-rate, and credit risks associated with them.
Those differences will affect a fund's yield and volatility. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance. Cash alternatives such as a money market fund can be used to park money until you decide how to invest it. Once you've covered the
basic three asset classes, there may be others that can be used to diversify further. There are various approaches to choosing an asset allocation that makes sense for you. One approach is to look at what you're investing for and how long you have to reach each goal. Those goals get balanced against your immediate need for money — for example, to pay living expenses.