If you haven’t read Parts 1 - 7 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
This is a good time to talk about diversification in your investments. In general, you want to avoid putting all your proverbial eggs in one basket, spreading your risk among several different types of investments. Deciding exactly how to spread this risk is called asset allocation and is a large part of what financial planners are paid to do. Asset allocation can be an extremely complicated subject, but hopefully we can simplify it somewhat so you can make some decisions.
This is a good time to point out that this post is going to focus on diversification of asset classes, but diversification also means buying multiple assets within that class, whether that means stocks, bonds, real estate properties, etc. One of the easiest and most popular ways to diversify is through the use of mutual funds. We'll talk more about mutual funds and index funds in the next section.
The basic idea behind diversification is that the best-performing type of investment is extremely difficult to predict because it may vary from year to year, or even month to month. Real estate may be a great investment vehicle one year and a terrible choice next year. American stocks may do well this year while overseas stocks suffer, and large financial services companies in Brazil may outperform Chinese manufacturing this year, but the reverse may be true next year. Therefore, diversification strives to choose asset classes that will balance each other out and reduce the volatility of market returns. Certain types of asset classes tend to move in opposite directions. For example, when stock returns suffer, bond returns usually increase. Therefore, an investor can theoretically reduce the volatility of their overall portfolio by choosing some bonds and some stocks.
The difficulty then becomes how to choose what asset classes to invest in and how much to invest in each. In general, there are two main variables that you need to consider when determining your asset allocation:
Although there are many different types of asset classes, we're going to keep it simple and stick with three major ones. These asset classes are easy to invest in and are passive investments:
Over the last hundred years or so, stocks have outperformed bonds and most experts recommend making stocks the backbone of your portfolio.
I'm going to now make some recommendations based on lots of information that I've read and things I've assimilated over time. Because asset allocation is such a complicated subject, many out there may disagree with me on these recommendations, and I would welcome any comments or suggestions. My goal here is to get people to start investing as soon as possible, as every single day counts in investing. You're not going to have a perfect asset allocation plan from this article, but you'll have a pretty good start, and in a few years, you can dig deeper into the subject. I think most investment experts would agree that it's better to start investing with a simplified asset allocation plan than to not start at all.
If you're still not convinced, there's a few decent asset allocation calculators out there that may help you decide what a good mix is for you:
Recommendations
I'm going to assume that this investment is for retirement. In general, the shorter your timeframe, the more conservative you'll want to be with your investments. If you're planning on using this money in less than 5-7 years, I would stick with cash or cash equivalents, like a high-yield online savings account.
For retirement savings, start by subtracting your age from 110. This is the percentage that you should hold in stocks, with the remainder held in bonds. So if you're 25, you should hold 85% of your portfolio in stocks and 15% in bonds. Pretty simple, but you'll want to rebalance your portfolio every year to adjust for changes (we'll go over this in more detail in a later lesson). If you're more comfortable with risk, subtract your age from 120. If you're less comfortable with risk, subtract from 100.
Within the stock category, I would choose something like the following:
The first number for each asset class is the percentage that risk-averse investors should allocate to that class. The second number is for those more risk-neutral, and the third number is for those that are more risk-tolerant. So for example, if you're relatively risk-averse, you would want 60% in large American stocks (which tend to be more stable), 10% in small American stocks (which tend to have higher volatility), and 30% in international stocks (which also tend to have higher volatility).
Task: Calculate your asset allocation.
Exactly which investments to buy is what we'll cover in the next lesson, but for now, just think about how much tolerance for risk you have and how long you'll be investing these funds for and come up with some idea of what asset classes you'll be investing in and how much. Remember that you can always change your asset allocation later (though you should minimize this). In fact, in a few years, once your portfolio begins to grow in size, it's probably a good idea to visit a financial adviser for more tailored advice, but we'll cover that in a later lesson, too.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.