Your Investment plan is more important than your actual investments.
– Ramit Sethi,I Will Teach You To Be Rich
Investing sounds sexy, fun, and like you’re being a real adult #amiright?!
But you really need to know a few basics before you start throwing your money into the market.
The most important part of your investment strategy – by far – is your asset allocation.
What is Asset Allocation?
Asset allocation is an investment strategy where you allocate your investments across several different asset classes, such as stocks, bonds, money market securities, real estate, etc.
Asset allocation not only includes “stocks and bonds” (aka equities and fixed income securities, respectively), it also includes mutual funds and exchange-traded funds (ETFs) that hold those securities. Cash includes certificates of deposit (CDs), US Treasury bills, or money market funds.
The goal of asset allocation is to minimize risk and maximize return across your entire investment portfolio.
Think of asset allocation as the “forest” and specific investments as the “trees”. The forests are the asset classes and the trees are the investments within the asset classes. You want to have many different types of forests (asset classes), whereas the types of trees (investments in the asset class) are less important.
Next, you need to consider diversifying your portfolio.
What is Diversification?
Your investment portfolio needs to be spread across many different asset classes in order to be diversified. Diversification means that you invest in many different asset classes in order to reduce your risk. Investing in several different stocks within one asset class is less effective at diversifying a portfolio than investing in several different asset classes.
Any sector of the market can crash at any time. If one sector crashes, you don’t want your whole portfolio to crash with it. Asset allocation prevents that from happening.
How to Choose Your Asset Allocation?
In terms of investing in the market, your asset classes typically fall into three categories: stocks, bonds, and cash.
Each category has subcategories, too.
Some of the subcategories are: large-cap stock, mid-cap stock, small-cap stock, international securities, emerging markets, fixed income securities, money market, and real estate investment trusts (REITs).
You have to decide what is right for you. Here are a few options.
A conservative portfolio has very low risk and very low rate of return. The main goal is to protect the principal (not to grow it). Usually, this is reserved for people who will need the money soon and who are older (think near retirement).
- 25% equities
- 45% bonds
- 30% cash
Moderately Conservative Portfolio
A moderately conservative portfolio is designed for someone whose goal is to preserve a large portion of the portfolio’s total value, but who is willing to take on a higher amount of risk to get some inflation protection. This is less conservative than the most conservative, but still conservative.
Moderately conservative example:
- 40% equities
- 40% bonds
- 20% cash
Moderately Aggressive Portfolio
A moderately aggressive portfolios is a balanced portfolio that has a higher level of risk than conservative portfolios, with the potential for greater return. This strategy is best for people who have at least five years or more left in the market and who are not too old.
Moderately aggressive example:
- 60% equities
- 30% bonds
- 10% cash
An aggressive portfolio has the highest risk and the highest potential rate of return. The main goal is to grow your investments. Usually, this is reserved for people who won’t need the money soon and who are younger (think 28 year old who is investing for retirement at age 65).
- 85% equities
- 15% bonds
Dollar Cost Averaging
Before you go start investing thousands of dollars all at once to create your ideal portfolio, I’d like to mention “dollar cost averaging”.
This is a finance phrase that means investing regular amounts of money over time. It’s better to do this than invest all at once because you lower your risk if the market drops. So, invest the same amount over time to build your portfolio.
Now the hard part is over but you’re not done! There’s clean up that you’ll have to do every year. Even though you decided on a specific asset allocation strategy for your investment portfolio, you need to maintain that. As the market moves, at the end of the year, so will your investments. For example, if your stocks (equities) grow and grow, you may end up with a higher percentage of equities at the end of the year than you desire if your approach is more conservative.
Therefore, you’ll have to “rebalance” your portfolio to maintain the percentage of asset classes that you desire.
Rebalancing is the process of selling portions of your portfolio that have increased significantly, and using those funds to purchase additional units of assets that have declined slightly or increased at a lesser rate. This process is also important if your investment strategy or tolerance for risk has changed.
A Final Note!
Investing can be intimidating and overwhelming.
If you want to get over that, I recommend reading about personal finance and investing (check out my book list), then starting small. You have to start somewhere and if you start now, one year from now you’ll be in a completely different place!