When it comes to investing for long-term financial goals like retirement or buying a house, most people tend to concentrate their efforts on the wrong things. Isn’t it important to figure out what direction the markets are going to go or which mutual fund has the best performance? While these factors are certainly relevant to achieving investment success, they aren’t what most people should be focusing on. More than any other decision, picking the right asset allocation is the single most important determinant of investment returns.
Why is this the case? Because picking the right combination of stocks, bonds, and real assets create a unique risk-return profile for a portfolio. Each asset class has different characteristics, but each is necessary to create a well-diversified portfolio. Stocks have historically provided the greatest return, but are also prone to extreme volatility, as in the 2008 financial crisis where they lost more than 30% of their value. Bonds, on the other hand, provide far lower return but provide a fixed-income stream that is stable. Real assets like commodities and real estate actually share some of the same characteristics with both stocks and bonds, but are relatively uncorrelated and can serve as an important hedge when the other markets are not performing well. When creating a portfolio that is appropriate for your financial objectives, it is important to keep in mind what each of these assets bring to the table. Below are some basic tips that will put you on the right track toward financial success:
1) Figure Out Your Own Risk Profile
Too many people jump into investing based on the advice of others without carefully thinking about their own unique situation. A sound investment strategy should be specifically tailored toward your needs and financial objectives. For example, if you are in your mid-20s and trying to save to buy a house in a couple years, your portfolio will look much different than someone in their late 30s trying to aggressively build their nest egg for retirement. Common rules of thumb suggest that young people who are just beginning their careers should pursue a more aggressive investment strategy, given that they have a longer time frame to reap the rewards of equity performance and are young enough to recover if the markets hit a downturn. Older people approaching retirement should be far more risk-averse, given that they are at a point where they are nearly ready to draw on their retirement savings and can’t afford to have the value of their portfolio suffer a dramatic decline. That said, these are just general guidelines – you have to carefully consider your own unique situation, and determine exactly how much risk you are willing to take.
2) Craft A Portfolio That Meets Your Objectives
Once you have figured out your risk profile, the next step is to create a portfolio that incorporates the right mix of assets. As mentioned earlier, the main tools that you have are stocks, bonds, and real assets. From the examples above, a young person in their mid 20s should have a heavily equity oriented portfolio (at least 60-70% equities). Bonds and real assets should be included for proper diversification, but ultimately young people should rely on equity allocation to drive returns and create their nest egg.
As you get older, your investment strategy should steadily become more conservative to protect the gains you have already locked in. The reason for this is that if the market crashes, you have less time before you retire for the market to sufficiently recover. It is not unprecedented for it take decades for a market to return to previous levels after a crash, and if you are in your mid 50s and still invested 70% in equities, it will spell terrible news for your retirement.
3) Re-balance Your Portfolio Periodically
One of the most sure-fire ways to have your portfolio become completely out-of-whack with your risk tolerance is to not rebalance periodically. Too often, people neglect their portfolio and let the market dictate their asset allocation. The most common way this can occur is after stocks have a particularly good year and compose a greater percentage of your overall portfolio. If you have a target equity allocation of 50%, you should rebalance your portfolio at the end of every year to make sure it remains at 50% (as long as your risk profile remains the same). In a bull equity market, this would involve selling equities and subsequently buying bonds or real assets. Conversely, in a bear market this would involve buying equities and selling bonds or real assets.
Also, as you get older, you should be re-evaluating your asset allocation targets and making sure that it corresponds with your risk profile.
Overall, if you keep these three tips in mind, you will be well on your way to achieving your financial objectives.
Joseph Egoian is an investment writer at NerdWallet, a site dedicated to helping consumers learn how to manage their money, whether it’s to help them find the best credit card for their needs, or find the right online brokerage account.