Why Asset Allocation is So Important

When it comes to investing, too many investors are focused on hitting home runs, in other words, doubling the value of their investments overnight. To do this, they take on too much risk and when the market drops, they lose everything. Frustrated, they claim the stock market is rigged against them and they leave.

Does this sound like you? If it does, then you need to read this post. Even if this isn’t you, you still need to understand the importance asset allocation plays in your long-term investing success. Below is a breakdown of how to get the most out of your investments while also being wise to risk.

Risk And Return Are Related

This is a basic concept but too many people ignore it. When you take on more risk, you potentially can expect more reward. But, this reward is not a guarantee. Too many investors take on way too much risk. They look at one side of the equation, the possibility of striking it rich overnight, and ignore the other side, where they can potentially lose everything. Don’t fall victim to this wishful thinking. You have to account for and accept that by taking on risk, you can lose everything. So how do you still earn a return and keep risk in check?

The easiest way to do this is to invest in a portfolio that is made up of stocks and bonds. This is because stocks and bonds tend to act opposite of one another and also because bonds do not have the volatility that stocks have.

To the first point, when investors are putting their money into stocks, there is great demand for those as opposed to bonds. Since supply and demand are related, stocks rise when there is more demand and bonds fall when there is less demand. The reverse holds true as well.

On the volatility front, stock prices vary widely because they are based on how much an investor values a company. Since one investor could place a different value on a stock as opposed to another investor, the stock price can be volatile. With bonds, you know how much you are getting based on the yield, so there is much less volatility with bonds. This is not to say that you can’t lose money in bonds however, because you can.

So, to lower your risk, you can invest in a portfolio made up of both stocks and bonds. The exact allocation will depend on your personal circumstances, but many investors go with a balanced portfolio of 60% stocks and 40% bonds. Again, you have to decide the right mix for you.

Allocating Stocks

While the above stock and bond portfolio is great, you can reduce your risk more and still earn a decent return if you allocate your stock holdings to various areas of the market. What do I mean by this? If you invest in different areas of the market, such as:

  • Large Cap US Stocks
  • Small Cap US Stocks
  • International Stocks (Large and Small)

you further reduce your risk. How is this so? There are many factors for this but there are 2 basic ones. The first is the large and small companies grow at different rates. Think of them like humans. A child (or small company) has immense growth and as such the stock price tends to be more volatile and has the room to grow. An adult (or large company) has matured and no longer grows as quickly (or in the case of humans, grows in different ways than height). They tend to still be profitable, but don’t grow as much. Therefore there is less volatility with these stocks.

As for international stocks, you have to look at economies. While the US economy might be struggling, the economy in Brazil or India could be flourishing. As a result, US stocks might be treading water while stocks in Brazil are growing.
By investing in both large and small companies both foreign and domestic, you allow yourself to join in on the gains while lessening your risk.

Adding It All Up

When you balance your portfolio correctly, with a good mix of large cap stocks, small cap stocks, international stocks and bonds, you can earn a good return while keeping risk in check. Of course, you still have to look at the long-term when investing because there will always be some volatility in the short-term.

So your homework is to look over your portfolio and make the necessary changes. What allocation is right? It all depends on your risk tolerance and your goals. There are some good resources out there to help you pick an allocation, such as this post. I would encourage you to do some more research though to really find a good allocation that meets your needs. There is a ton of information out there on building a portfolio and you can be sure to find one that helps you.

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