If you’ve ever been stuck in heavy traffic, you know how it always goes: you’re surrounded by hundreds of cars trying to get to the same place as you; your path is going nowhere and everyone around you seems to be doing well. Until you change lanes, that is. That’s when your old path begins to advance and your new path stops. Sound familiar?
These days, navigating the financial markets is a lot like being stuck in heavy traffic. You’ve invested your money in a traditionally strong asset class – real estate or common stocks, for example – but it doesn’t seem to be going anywhere. So you move it to a sector of the market that seems to be performing better, and what happens? Your old asset class takes off and the new one shuts down, leaving you and your asset accumulation plans nowhere.
Changing investment strategy in response to poor performance – much like changing lanes in heavy traffic – carries a number of potential risks. National and world events, changes in the economy, and even bad weather can all affect what happens to your money on a daily basis. There’s simply no way to look down the road to see what’s coming and no guarantee that your new strategy will work better than the old one.
So how can you get out of the “slow lane” and position yourself to better take advantage of periodic upsides in more than one financial market sector? For many investors, the answer is an asset allocation strategy.
Asset allocation is all about spreading your money across several different asset classes (stocks, bonds, mutual funds, CDs, annuities, etc.) to reduce your exposure to losses and increase your opportunities for growth . Portfolios that include different types of investments generally benefit from a higher degree of protection against market volatility than those that do not. For example, when stock prices rise, bond prices generally fall and vice versa. If you have money invested in both stocks and bonds, losses you incur in one investment can potentially be offset by gains in the other.
How do you decide which type of asset allocation is right for you? The answer largely depends on your risk tolerance and investment time horizon. If you’re the type of person who stays up at night worrying about what the stock market is going to do, you probably have a low to moderate tolerance for risk. If you’re not so concerned with what the markets are doing on a day-to-day basis and you’re willing to take bigger risks in order to make potentially bigger gains, you might want to consider more aggressive investing. Either way, your asset allocation strategy should reflect your risk tolerance.
Your investment time horizon is simply the number of years between now and when you will need access to your money. The longer your investment horizon, the more time you will have to recoup potential losses. People with long-term investment horizons are often more comfortable investing in riskier but potentially more rewarding investments. Conversely, the closer you are to needing your money, the less comfortable you will be putting it at risk. People approaching retirement, for example, tend to put their money in less risky and more conservative investment vehicles.
Once you understand your risk tolerance and time horizon, you will likely base your asset allocation strategy on one of four general asset allocation models: capital preservation, income, income and growth (balanced) or growth.
Capital preservation models are largely designed for investors who expect to need their money in a few years – people who are unable or unwilling to put some of their capital at risk. Income models are designed for people who need current income. These are usually people who are nearing retirement or nearing retirement or have others who depend on them for support. Balanced models tend to strike a balance between capital preservation, income and growth, and are typically comprised of an asset mix that appreciates over time and generates current income. Balanced models are ideal for people who still have time to accumulate assets, but do not have a particularly high risk tolerance. Finally, the growth models are designed for people with a long-term investment horizon and an above-average tolerance for risk. These are usually younger people who are working and just starting an asset accumulation program.
No matter where you are in life, it’s never too late to develop an asset allocation strategy, especially if you feel stuck in the “slow lane” when it comes to your investments. The right asset allocation will not only help you maintain your confidence in the turbulent waters of the economy ahead, but it could also increase your potential for better returns over the next few years. Keep in mind, however, that neither diversification nor asset allocation guarantees profit or guarantees against losses.
You can’t drive in three lanes of traffic at once, but by working with a trusted finance professional, you can get back on the path to a secure financial future.
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