Putting money into investments for your future sounds like a smart idea. The horizon you envision might be a year from now or more than 20 years from now. You could be aiming for early retirement, life as an entrepreneur, or wealth to pass down to your heirs. You’ve heard building a diversified portfolio of stocks, bonds, and other types of investments is best. It lowers your risk while helping you achieve a desirable return.
But it’s easy to get tripped up when you’re trying to put theory into practice. Terms like mid-cap, large-cap, and index funds reveal the complexities of the market. You might start to wonder how much you should invest in stocks, bonds, and cash equivalents. You could also consider investing in real estate through market funds or individual properties.
When it comes down to it, diversification is about allocating your assets. You don’t want everything tied up in one type of investment. Instead, you want to devote specific percentages to a mix according to your risk tolerance. The right combination for you will also depend on your goals and how much time you have to reach them. We’ll explore the art of asset allocation and provide tips on how to build a diversified portfolio below.
Consider Your Financial Goals
When you look at historical return data, stocks tend to outperform bonds. The riskier the investment, the higher the return potential. But does this mean your entire portfolio should be in stocks, especially ones with more volatility? Probably not.
How much of your money goes to riskier investments will depend on what you want the outcome to be. Are you more concerned with achieving a bigger return or preserving your money? You may have a desired rate of return in mind, such as 10%. Perhaps you’re not set on a specific return rate, but you know you want to grow $100,000 to $500,000.
In general, bonds and cash have a lower rate of return over time. However, their value usually doesn’t fluctuate as much as stocks. You can still grow your money, but it probably won’t grow as much or as fast. This could be an acceptable trade-off to you if the investment helps you reach your goal. For instance, a CD with a 4% annual return may be enough to meet your financial objectives.
A diversification strategy balances out the risks and rewards of each asset type. Say your goal is to grow your portfolio to $1 million in 10 years. In this case, you’ll probably need to invest more heavily in stocks. But you do want a smaller percentage to go to bonds and cash equivalents to even out the risk. Your chances of losing the bulk of your portfolio’s value go down while your projected return rate remains high enough.
Determine Your Risk Tolerance
You can think of risk tolerance as how much you’re willing to gamble with your money. When risk factors increase with an investment, so does the probability of loss. Risk tolerance is highly subjective, and it can change throughout your lifetime. Your personal risk tolerance might be linked to your age or stage in life. Or your willingness to absorb potential losses could tie in with your feelings about risk in general.
With regard to determining your risk tolerance, Lifestyle Investing expert Justin Donald says it’s “a matter of personal choice, and there is no right or wrong answer. Risk-taking is comfortable for some, while safety is more important for others.” So if you lean more toward stability, you’ll want to choose a higher percentage of conservative investments. Think bonds, high-yield CDs, and stocks with lower volatility.
At the same time, having a lower risk tolerance doesn’t mean you’ll want to completely avoid riskier choices. Your portfolio will just have a smaller percentage of alternative investments like real estate investment trusts and cryptocurrencies. You could lose value with those choices, but your overall portfolio could still produce a gain. It’s because most of your investments earn a small but steady return over time.
Say you decide it’s time to lay all your cards out on the table. You’re going for the possibility of big gains. This requires that your risk tolerance lean toward the higher end, and you’ll allocate more assets to choices with increased volatility. You could invest heavily in high-risk stocks, alternatives like hedge funds, or even private equity.
Establish Your Timeline
The time you have to achieve your financial goals will influence your portfolio’s asset allocation. When investors have less time to meet their targets, they’ll usually be more concerned about stability. With a longer timeline, investors will typically be able to absorb higher risks. For instance, you might lose 20% on a stock in one year. However, your 10-year return rate may average out to 12%.
Target-date funds are an example of a timeline-oriented diversification strategy. You’ll typically see these options in employer-sponsored 401(k) plans. Say you plan to retire in 2045. A target-date 401(k) fund will skew toward stocks and higher-yield investments the further away you are from your retirement date. As 2045 gets closer, the fund will shift its asset allocation toward conservative investments.
The goal is to earn more while you can afford to take risks and preserve value when you can’t. Target-date funds are a way to automate asset allocation according to a specific timeline. You don’t have to reallocate as time goes on, since the fund managers do it for you. But you can use a similar strategy if you prefer a hands-on approach.
Perhaps you want to leave your job and launch a business in two years’ time with the proceeds of your investments. Your timeline is short, so you’ll want to avoid a higher potential for loss. Your portfolio will probably steer toward stable assets with the highest possible yield. Those assets might be higher-earning cash equivalents you can liquidate without penalty fees in two years. But if your timeline is over five years, you can choose somewhat riskier assets with greater earning potential.
Diversifying Your Investments
Financial experts recommend diversifying your investments because it tends to balance your potential risks and rewards. When you put all your money into a single asset, your returns are at the mercy of that investment’s performance.
It’s like having equity in only one property. If the market value tanks, all your equity could get wiped out. But if you have equity in multiple properties, your risk of losing everything goes down. When one property appreciates, it can make up for any lost value in another.
Nonetheless, diversification strategies look different for each investor. How you allocate your assets will depend on your goals, risk tolerance, and timeline. And your approach will likely change as those factors evolve. The most important thing is to continually allocate your assets in a way that works in your favor.