Beginner's Guide to Asset Allocation, Part 2

In Beginner's Guide to Asset Allocation, Part 1, we discussed things to consider in Asset Allocation.

In Part 2, we will take a closer look at the different asset categories and investment choices.

Investment Choices
For most investors, investing in a mix of stocks, bonds, and cash is the best asset allocation strategy. However, before you make any investment, it is very important for you to understand the risks of the investment and make sure the risks are appropriate for you. Let's take a closer look at the characteristics, and associated risks, of the three major asset categories.

Stocks - Stocks have historically had the greatest risk and highest returns among the three major asset categories. As an asset category, stocks are a portfolio's "heavy hitter," offering the greatest potential for growth. Stocks hit home runs, but also strike out. The volatility of stocks makes them a very risky investment in the short term. Large company stocks as a group, for example, have lost money on average about one out of every three years. And sometimes the losses have been quite dramatic. But investors that have been willing to ride out the volatile returns of stocks over long periods of time generally have been rewarded with strong positive returns.
  
Bonds - Bonds are generally less volatile than stocks but offer more modest returns. As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor despite their lower potential for growth. You should keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.
  
Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories. The chances of losing money on an investment in this asset category are generally extremely low. The federal government guarantees many investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do occur, but infrequently. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time. 

Stocks, bonds, and cash are the most common asset categories. These are the asset categories you would likely choose from when investing in a retirement savings program or a college savings plan. But other asset categories - including real estate, precious metals and other commodities, and private equity - also exist, and some investors may include these asset categories within a portfolio. Investments in these asset categories typically have their own category-specific risks. REMEMBER: Before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.

Why Asset Allocation Is So Important
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

If you are new to investing, a real life examples may help you to understand this fundamental principle of sound investing.

A vendor may sell seemingly unrelated products - such as umbrellas and sunglasses. Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never... and that's the point! When it's raining, it's easier to sell umbrellas, but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items, or diversifying, the vendor reduces the risk of losing money on any given day.

In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family's summer vacation.


If you need to take a break, because all this financial talk is making your head hurt, please do!

If you want to forge ahead, read on to find out how to get started with your asset allocation in Beginner's Guide to Asset Allocation, Part 3.