Please enjoy part 5 of Key Investment Concepts from the FINRA - TopicsExpress



          

Please enjoy part 5 of Key Investment Concepts from the FINRA Foundation. 5. Allocating Your Portfolio Possibly no decisions you make have a greater impact on the investment return you achieve than how you choose to allocate your portfolio. When you use asset allocation as an investment strategy, you decide how much of your principal to invest in each of the different asset classes, or investment categories. For example, you might decide to put 80 percent of your assets in stock, 10 percent in bonds and 10 percent in cash equivalents. Or you may decide to put 60 percent in stock, 35 percent in bonds and 5 percent in cash. Asset allocation can make a major difference in both your investment return and level of investment risk. Because each asset class has its own unique characteristics and risks, the performance of your overall portfolio will partly reflect the asset mix you choose. For example, compared to bonds, cash and real estate, stock is the most volatile asset class in the short run, but over longer periods has outperformed those other asset classes. So a portfolio heavily allocated in stock is likely to be volatile in the short term, but has the best chance of providing strong returns over 15 years or more. On the other hand, a portfolio heavily weighted in bonds will tend to provide predictable income but considerably more modest returns over a similar term—though there may be some years when the return on bonds is stronger than the return on stock. The Right Mix One of the chief benefits of asset allocation is that you can offset some of the characteristics of one asset class with those of another. For instance, a portfolio that includes a substantial percentage of stock, but also some bonds, may have the potential to provide much of the robust growth associated with stock while reducing some of the risk of volatility. Similarly, a more conservative investor might be able to boost returns in a portfolio heavily allocated in bonds, without necessarily increasing volatility, by including a percentage of stock in the asset mix as well. Asset allocation can also provide a buffer to broader economic conditions, since various asset classes can react in different ways to changes in the financial markets. One example is that, historically, stocks have tended to provide strong returns in periods when interest rates are low, and bonds have tended to slump in those periods. The opposite has been true when interest rates increase. When asset classes react in a similar way to particular economic environments, providing similar returns over a period of time, they are described as highly correlated. But when classes react differently or to different degrees to the same situations, they are said to have a low correlation. As the example of response to interest rates illustrates, stocks and bonds generally tend to have a low correlation. In some instances, assets also can be negatively correlated, which means that their returns tend to move in different directions in response to similar situations. For example, during times of rising interest rates, real estate historically has held up well, while stocks have provided disappointing returns. By spreading your principal across different asset classes, taking care to include those with low correlations and negative correlations, if possible, and leaving that allocation more-or-less in place over a number of years, you are in a position to benefit from whichever asset class happens to be outperforming the others. That means you can offset potential losses in an underperforming asset class with values or gains in another. Your Investing Style How you decide to allocate your assets—whether you choose a conservative, moderate or aggressive allocation mix based on your tolerance for risk—is sometimes called your investing style, or profile. Your investing style reflects your personality, but it is also influenced by other factors like your age, financial circumstances, investment goals and experience. For example, if you are approaching retirement or have lived through a period of major economic upheaval, such as a recession, you may be inclined to invest more conservatively. That might also be the case if you run a small business or are the sole provider for your family. On the other hand if you’re still early in your career, have few financial responsibilities or own substantial assets, you may be willing to take more risk in your portfolio because you don’t need all of your current assets to meet your financial obligations. Conservative Investing Style Conservative investors make capital preservation, or safeguarding the assets they already have, their priority. Because they normally aren’t willing to put any of their principal at risk, conservative investors usually have to settle for modest returns. The portfolios of conservative investors are typically heavily allocated in bonds, such as U.S. Treasury bills, notes and bonds, highly rated municipal bonds, and insured investments, such as certificates of deposit (CDs) and bank money market accounts. While conservative investors tend to avoid stock because of its volatility, they may allocate a small portion of their portfolios to large-company stocks, which sometimes pay dividends and tend to be more stable in price than other types of stock. The Risks of a No-Risk Portfolio As counterintuitive as it may sound, avoiding risk altogether can make conservative investors vulnerable to other types of risk—notably inflation risk. If you invest so conservatively that your invested assets barely keep pace with the rate of inflation (which has averaged 3 percent annually since 1926, but can sometimes spike higher), then your invested assets may barely be growing at all in terms of real buying power. If you’re also paying taxes on those assets, then they may in fact be shrinking compared to inflation. That’s why a conservative investment strategy can make it difficult to meet long-term investment goals, such as a comfortable retirement. When a Conservative Approach Makes Sense There are some circumstances, however, when a conservative approach to investing may be appropriate. If you’re investing to meet shorter-term goals—for instance, you plan to make a down payment on a house in the next two or three years—then you may not want to put those assets at risk by investing in volatile securities, since your portfolio may not have time to recover if there’s a market downturn. Similarly, if you have substantial amounts of money invested in your own business or have other major financial responsibilities, you may be more comfortable taking a more conservative approach with your investment portfolio. Moderate Investing Style Moderate investors seek a middle course between protecting the assets they already have and achieving long-term growth. They strive to offset the volatility of growth investments, like stocks and stock funds, by allocating a portion of their portfolios to stable, income-producing investments, such as highly rated bonds. While moderate investors may favor large-company domestic and international stocks, they may also diversify their portfolios by investing in some more volatile small-company or emerging-market stocks, to take advantage of the potential for higher returns. There is no hard and fast rule about exactly what mix of assets is appropriate for someone striving to achieve a moderate asset mix, since that mix depends to some extent on individual circumstances and tolerance for risk. For instance, a portfolio that is invested 35 percent in large cap domestic stocks, 15 percent in small-company and international securities, and 50 percent in bonds, might be considered very moderate—even conservative—for someone with 30 or 40 years until retirement. However, this same asset mix would carry more risk for someone with only a few years until he or she retires. If you’re not a risk taker by nature, a moderate investing approach may make sense in almost all circumstances. In broadest terms, a moderate approach means finding the mix of assets that gives you both the potential for long-term growth yet adequate protection for your assets given your age and financial circumstances. Aggressive Investing Style Aggressive investors focus on investments that have the potential to offer significant growth, even if it means putting some of their principal at risk. That means they may allocate 75 percent to 95 percent of their portfolios in stock and stock mutual funds, including substantial holdings in more speculative investments, such as emerging market and small-company stock and stock funds. Aggressive investors with large portfolios may also allocate some of their assets to private equity funds, derivatives, direct investments and other alternative investment products. Aggressive investors tend to keep only a percentage of their assets in cash and cash equivalents so they maximize their potential returns but have cash available when new investing opportunities arise. An aggressive approach is best suited to people with 15 years or more to invest to meet a financial goal, and who have adequate resources, so that they can absorb potential losses without jeopardizing their financial security. While past performance is no guarantee of future results, history demonstrates that an aggressive investing style coupled with a well-diversified portfolio, combined with the patience to follow through on a long-term strategy, can be very rewarding in the long run. Contrarian Investing Style A contrarian investor’s approach is to flout conventional wisdom. Contrarians buy investments that are currently out of favor with the market and avoid investments that are currently popular. But contrarians aren’t just trying to be different—there is a method to their being contrary. Specifically, they believe that stocks that are undervalued by the market may be poised for a rebound, while stocks that are currently popular may be overvalued, have already peaked or may not be able to meet investor expectations. A contrarian strategy isn’t for everyone. You need experience and the willingness to do lots of research to be able to discriminate between companies that may be undervalued and those that are simply performing poorly. You also need patience, since it can take time before a stock makes a turnaround. Consistent with having a well-diversified portfolio, you may want to use this approach with only a portion of your portfolio—perhaps by choosing a mutual fund with a contrarian style.
Posted on: Tue, 16 Dec 2014 18:46:44 +0000

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