With literally thousands of stocks, bonds and mutual funds to choose from, picking up the right investments can confuse even the most seasoned investors. Instead of making any improper decision it is better to start by deciding what mix of stocks, bonds and mutual funds you want to hold, this refers to as asset allocation.
Asset allocation involves division of an investment portfolio among different asset categories. The process of determining which mix of assets to hold in your portfolio is a very critical and personal thing to consider. The asset allocation that works best at any given point in one’s life will depend largely on time horizon and ability to tolerate risk.
When it comes to investors we usually find two tendencies I. e “aggressive” and “conservative”. An aggressive investor or one with a high risk tolerance, is more exposed to risk of losing money in order to get better results. A conservative investor or an investor with a low risk tolerance tends to favor investments that will preserve his or her original investment. In the words of the famous saying conservative investor keeps a “bird in the hand” while aggressive investor seeks “two in the bush”. When it comes to investing, risk and reward are inextricably entwined. All investments involve some degree of risk, if you intend to purchase securities such as stocks, bonds, or mutual funds it’s important to understand before investing that one can lose some or all of the money.
Stocks, bonds and cash are the most common asset categories. But other asset categories including real estate, precious metals and other commodities and private equity also exist and some investors may opt for these asset categories. Before making any investment it is significant to estimate the risks and making it sure that they are appropriate for the individual.
By merging asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect himself against significant losses. By investing in more than one asset category, one can cut the risk to lose money and portfolio, in this way overall investment returns may have a smoother ride.
The practice of spreading money among different investments to reduce risk is known as “diversification”. This strategy can be neatly summed up by the ever green phrase. “Don’t put all your eggs in one basket”. It involves spreading money among various sections in the hope that if one investment loses money the other investments will make up for those losses.
The decision about asset allocation goes hand in hand with asset location. It is important that how investors distribute their investment across saving vehicles including taxable accounts, tax exempt accounts, tax deferred accounts, variable life insurance policies, foundations and onshore vs. offshore accounts. Asset location is a tax minimization strategy that takes advantage of the fact that different types of investments get different tax treatments.
Some financial experts believe that determining the asset allocation and location is the most important decision that one has to make before initiating investments. Determining the appropriate asset allocation model for a financial goal is a complicated task but a consultation with a professional can minimize the risk.