Do you know the old saying, “don’t put all your eggs in one basket”? If so, then you’ve had your first lesson in asset allocation and diversification.
Asset Allocation and Diversification
When it comes to investing, you have important decisions to make about dividing your investment dollars.
Diversification is deciding to hold more than one type of investment, such as buying stock in several different companies, so you minimize your risk of losing all your money if one of your investments goes bad.
Asset allocation is a diversification strategy that goes one step further. With asset allocation, you don’t just buy a variety of one type of investment, you purchase investments that span several categories. This minimizes your risk of losing it all when one investment fails, plus it helps you meet your financial goals because not only are you balancing risks, you’re also balancing potential rates of return.
Three Categories of Investments
There are three main categories of investments:
- Cash: This category includes CD’s, savings accounts, money market accounts, money market funds and treasury bills. Cash and cash-equivalent investments are by far your safest option (many are even federally-guaranteed), but they also bring the lowest rate of return.
- Bonds: Bonds tend to occupy the middle ground between cash and stocks. They are generally more stable and less risky than stocks. By the same token, they tend to offer a lower rate of return than stocks.
- Stocks: The stock market offers the highest level of risk as well as the highest potential rates of return for any of the three categories of investments. Especially in the short-term, stocks tend to be volatile investment vehicles, and watching your stocks day-to-day can be a bit of a roller coaster ride. As a long-term investment, though, stocks on the whole have historically done well.
Allocating Assets Depends on Your Goals
Selecting a mix of investments depends on your financial goals, the length of time you want to invest before achieving your goals, and your tolerance for risk.
So, if your financial goal is saving for retirement, which is several decades away, you may choose to initially shift the balance of your investment portfolio toward higher-risk stocks, on the theory that you can ride out any volatility in the market in favor of long-term gains. Then, as you get closer to retirement age, you’ll likely want to re-allocate your assets in favor of a heavier mix of bonds, to provide more stability and predictability in your portfolio as you near your goal.
Carefully allocating your assets can help you give you peace of mind as you work toward your financial goals.