Understanding Asset Allocation
Go ahead and think about your clothing. If you’re like us, you have clothing for work, clothing for summer, clothing for nights out with family and friends, clothing for the beach, etc. Suppose you determine that 20% of your clothing is suitable for work, 20% is suitable for nights out and 60% is suitable for time at the beach. If you actually spend 70% of your time at work, this particular mix of clothing would not make particularly good sense for your lifestyle.
What is asset allocation?
Asset allocation is just a fancy way of saying asset mix. If 60% of the value of your assets is stocks, 35% is bonds and 5% is cash equivalents, then you have a 60/35/5 asset allocation to stocks/bonds/cash. It’s that simple.
What’s the best asset allocation?
There isn’t a “best” asset allocation because every individual’s situation is different. The best asset allocation for you is one that is tailored to you and your current and particular financial situation, goals, risk tolerance and time horizons.
How to think about it
In general, cash and cash equivalents are appropriate investment for short-term financial goals. This might be something like saving for down payment on a house in one year. Bonds are appropriate for medium-term goals. This might be something like saving for a car you plan to purchase in five to ten years. Stocks are appropriate for long-term goals. This might be something like saving for retirement in 20 to 30 years. These are just guidelines. Any number of circumstances particular to you might cause you to tweak these guidelines.
Your asset allocation isn’t static
Asset allocation isn’t a set it and forget it kind of thing. Your current asset allocation should match your current situation. Time alone will shrink your time horizon for all your financial goals. Short-term goals have an end date. Medium-term goals become short-term goals. Long-term goals become medium-term goals. You should slowly change your asset allocation to reflect your changing situation. In general, your risk tolerance will slowly decline over time. If you add new goals, your asset allocation should change to reflect this change.
Target date products
There are a number of investment products on the market that will gradually and automatically change your asset allocation from higher risk assets to lower risk assets over time to reflect your changing risk tolerance due to your shrinking time horizon. These products are typically date specific to align with your age or retirement date. For example, “Retirement Date 2055 Fund.” The fund company will have several different target date funds in order to accommodate all of their clients. They will all follow the same changing asset allocation lifecycle. Where in the lifecycle the fund is will depend on the target date. After the target date, the asset allocation remains static at the final and most conservative asset allocation. These products are designed for investors who do not want to slowly change their asset allocation on their own.
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