As many investors have learned the hard way in recent years, building wealth while preserving principal is not about riding the hot sectors or even picking the "best" investments. It's about investing regularly over the long term with a diversified portfolio. Your portfolio's asset allocation - the mix of investments you choose - is key to achieving diversity and maximizing risk/return efficiency perhaps even more than your choice of actual investments. Whether you dream of retiring in style, sending your children to the university of their choice or starting your own business, how you allocate your assets will be critical to achieving your goals.
Finding the Right Asset Allocation for You
A diversified portfolio begins with three main asset classes: stocks, bonds and cash. Each of these performs differently in different situations. They also offer different levels of risk and potential returns. The tricky part is deciding what mix of investments is right for you.
When it comes to building your own portfolio, your investments should reflect your age, your individual needs and goals, and the overall economy. But since these factors are fluid, allocating your assets is truly an ongoing process. You should review your asset allocation regularly to make sure it's still in line with your current situation. Also, it is important to remember that asset allocation and diversification do not assure a profit or protect against a lost.
Stocks. Stocks represent shares of ownership in the companies that issue them. As between stocks, bonds and cash, stocks historically have proven to be the best opportunity for long-term growth (rather than short-term income). Though more risky than bonds or cash, stocks have produced higher average annual returns over time and generally offer the best long-term potential hedge against inflation. According to Ibbotson Associates, a respected financial services consulting firm, there has been no 15-year or longer period where stocks, as represented by the S&P 500 index, didn't seen a gain. Fifty-four of the past 76 years have seen the stock market gain money. It should be noted though that past performance does not guarantee future results.
It's also important to diversify your stock holdings. Growth and value stocks should be well-represented in your portfolio, with exposure to large-, mid- and small-caps, as well as international and sector funds, depending on your risk tolerance. A financial professional can help you select stocks based on indicators such as projected earnings per share, growth, price-to-earnings ratio, etc.
Bonds. Bonds are certificates of debt issued by corporations and governments when they borrow money. In repayment for the loan, bond issuers promise to pay interest to the bondholder for the life of the bond. These interest payments can provide current income to the bondholder. At maturity, the bond is retired and the principal amount repaid. A rise in interest rates generally results in a decline in the value of a bond, and vice versa. Bond prices tend to fluctuate less than stock prices, and some bonds provide income-tax-free interest payments.
Cash. Not only the green stuff that lines your pocket, "cash" also includes taxable and tax-free money market funds, CDs and treasury bills. These are among the lowest-risk investments, but they also provide lower potential returns compared to stocks and bonds, with CDs and treasury bills fluctuating less than money markets.
Get Assistance and Review Your Portfolio Regularly
You can access general online asset allocation tools through investment Web sites, but you might also wish to seek the advice of a financial professional to fine-tune your specific financial goals. He or she can help you create a sound asset allocation plan based on your unique needs and risk tolerance.
But simply creating an asset allocation strategy is not enough. Together with your financial advisor, you should examine your portfolio frequently to help assure that your asset allocation is not shifting significantly because of movements in the market or changes in your own personal situation.
