A MOMENT OF CLARITY
Portfolio Basics: Asset Allocation, Time Horizon, Risk Tolerance and Diversification
Investing can seem daunting at times for those that are just starting out. There are several concepts that need to be mastered to comprehend how to build an investment portfolio based on your specific needs. This article will help you familiarize yourself with some of these concepts and serve as a starting point.
Asset allocation is the act of dividing an investment portfolio into various types of investments “asset classes” like cash, bonds and stocks. The purpose is to help mitigate significant increases and decreases in the portfolio’s value. For example, if you follow the stock market, you will notice that any given day stock prices can appreciate significantly followed by a drastic decline the next day, and vice versa. This is often referred to as volatility. If this makes you uncomfortable, then you need to consider adding other types of investments that will help alleviate the volatility in your portfolio. Think about asset allocation as picking a mix of investments that has the highest probability of meeting your financial goals within the time horizon you have set for each one, and at a level of risk you can live comfortably with.
Depending on the purpose of your portfolio (retirement, college, building wealth, etc.) ask yourself how much time you have to achieve a particular financial goal. The longer your time horizon, the more time you have to recover from a loss in the value of your investments. For example, imagine investing for retirement in your 20’s vs in your 50’s; a significant financial loss will mean a lot less in your 20’s than it would when you are 50 years old.
Risk tolerance is one’s ability and willingness to lose some or all of your original investment in exchange for potential returns.[i] If you include asset classes that have different investment returns under certain market conditions, you can protect yourself from suffering more than what you need to. It does not mean you will not have losses, but it could certainly help you avoid unnecessary ones.
You know the saying: “Do not put all your eggs in one basket.” The “eggs” represent your money and the “baskets” represent the different investments you get to choose from. In addition to stocks, bonds, and cash, which are the three major asset classes, there are sub-categories within each asset class that need to be managed. Some examples include sectors (financials, materials, energy, technology, health care, etc.), industries (the different categories inside of any given sector, like pharmaceutical and biotech are industries within the healthcare sector), company size (large cap, mid cap, and small cap) and the countries where they sell their goods and services. Incorporating all these within your investment portfolio is not an easy task but is still a necessity to mitigate undue risk in your portfolio.
Your Investment Portfolio, just like any other area of your life, requires time, patience, and discipline. Surround yourself with professional resources and always plan for change, knowing that the markets are dynamic and are constantly moving.
If you would like more in depth information about these topics, you can go to our website and take a look at our blog on Portfolio Theory and Diversification, or contact a Round Table Wealth Management Advisor today.