Asset allocation (AA) is a common investment strategy that involves putting your money into different, unrelated asset classes. Since these assets are not connected, in theory they should move in opposite directions. This diversification can help you maximize returns while also reducing the overall risk in your portfolio. It’s important for young investors to understand asset allocation. Used properly, it can help you achieve your retirement goals.
Perhaps you are unsure of how to get started. Let’s explore the steps involved in picking the right asset allocation for you.
Know Your Goals
The first step in good asset allocation planning is determining your goals. As a young person, you probably have a very long-term investment time horizon. It will be many years before you need to pull money out of your retirement accounts. A long-term outlook means more tolerance for risk and a more aggressive approach to investing. You will be able to ride out any short-term market fluctuations and stay on track to achieve your goals over time.
So, which allocation should you choose? Let’s look at a sample portfolio for an investor in their mid-20s. Keep in mind that this is just an example. Every person has different needs. Don’t be afraid to consult a financial advisor if necessary. Base your asset mix on your age and personal risk tolerance. You don’t want your investments keeping you up at night!
Aggressive Asset Allocation Model Portfolio
In this example, our investor holds multiple assets in their portfolio. As you can see, stocks make up most of the mix. This investor has determined that the long-term growth potential for stocks outweighs the risks. Alternative assets, commodities, and Real Estate Investment Trusts (REITs) round out the portfolio and provide potential for capital appreciation. Since this investor is young, bonds and cash are just a small part.
Pick Your Investments
Once you figure out your allocation, the next step is to pick your investments. This depends on your account type. For example, if you have a 401(k) you will be stuck with your company’s investment options. These are usually limited, although you should be able to put together a basic portfolio. If you are using an Individual Retirement Account (IRA) or a brokerage account, you will have more investments to choose. I recommend constructing your portfolio using low fee index Exchange Traded Funds (ETFs).
ETF List For Sample Portfolio
Stocks – IVV, EEM, EFA
REITS – VNQ
Commodities – DBC
Alternatives – HDG
Bonds – AGG
This list is just to get you started, do your research and find the right ETFs for you.
So, you have picked an allocation and constructed a portfolio. Now what? Can you just sit back and do nothing? No, although asset allocation does not require active investing, it does require balancing. Rebalancing involves trimming or adding to you existing asset classes. Do this in order to make sure that your portfolio allocation is still in line with your long-term objectives.
Rebalance your accounts quarterly, every three months. For example, let’s say you set your allocation to hold 75% stock. A recent market run up has increased that to 80%. During your next rebalance, you would trim 5% out of your stock holdings and use those proceeds to reinvest into your other asset classes.
Adjust Over Time
As you get older, you will need to adjust your strategy and make it more conservative. This usually involves moving from riskier assets like stock into more stable, fixed income investments like bonds. Re-evaluate your long-term goals every five years or so and shift to safer investments as you age.
Asset allocation is not a perfect investment strategy and it has its critics. Although it is not faultless, it is a good way for young investors to maximize portfolio returns while reducing risk. Used correctly, it can help you achieve your long-term retirement goals.
Mario Favela is a freelance content writer living in Austin, Texas. He writes about business and investing at his blog Gator Finance.
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