Most financial professionals preach the virtues of asset allocation. This is the idea of building an investment portfolio with certain amounts invested in each of the chosen asset classes. Asset classes are merely groupings of investment assets.
Whew! You almost need a investing dictionary or glossary!
Common asset classes include:
- Large Cap US Stocks
- Mid Cap US Stocks
- Small Cap US Stocks
- International Stocks from Developed Countries
- International Stocks from Developing Countries
- Investment Grade Bonds
- High Yield or Junk Bonds
- Government Bonds
- Municipal Bonds
Asset allocation then is investing your money in these, and other asset classes, in the proportions that fit your time frame and risk tolerance.
Making Investments More Conservative
Since there is no exact answer as to what asset allocation is best, there is some gray area when it comes to determining what mix of asset classes is best for each person.
However, certain asset classes have historically been less volatile than others. Theoretically, having more of these in your portfolio will make it more conservative.
Historically, government bonds are less volatile than municipal bonds, which are traditionally less volatile than stocks of large US companies, which are less volatile than stocks of small US companies, which are less volatile than the stocks of international companies. But, as history teaches us, there is no guarantee that this will be the case every year.
However, over longer periods of times, this paradigm holds up fairly well. So, an investor looking to get more conservative would shift their asset percentages down the risk ladder so that they have less in riskier stock investments and more in less volatile investments such as U.S. Treasuries and high-rated bonds.
There is an important note here. Junk Bonds are often very volatile especially during tough economic times, so increasing your allocation to high yield, or junk bonds (they are the same thing) does not make your portfolio more conservative.
Instead, stick with investment grade bonds and government and municipal bonds for less volatility. Keep in mind that even these investments can and do go down in value. More conservative does not mean safe, it means that their value won’t fluctuate as greatly as less conservative investments over a reasonable period of time.
It is also important to note that shifting to more conservative asset allocation does not mean to eliminate investments in stocks or even international stocks, but rather to cut back on the amount given to them. Most financial professionals don’t recommend a split greater than 60% bonds / 40% stocks to anyone other than their most skittish clients who are already retired and living off of their investment income.
An oft quoted rule of thumb is to subtract your age from 100 and use the resulting number as your allocation to stocks with the remainder going into bonds. For example, a 45 year old would allocate 55 percent (100 - 45) to stocks and 45 percent to bonds.
The most important thing is to stick to your asset allocation strategy during the market ups and downs. Frequently changing your allocation is just another type of market timing.
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