What is asset allocation? How is my money being invested?
Your Risk Tolerance is your ability and willingness to lose some or all your investment in exchange for a potentially greater return. A higher risk tolerance typically correlates to a more aggressive portfolio allocation and vice versa. Risk directly impacts the return you’re trying to achieve. All investments involve a degree of risk – if you are worried about losing your funds then you would likely want to reduce the risk of your portfolio instead to preserve capital.
Three Major Asset Categories:
Bonds are generally far less volatile than stocks but offer more modest returns. Bonds are essentially IOUs from either the government or a company that state the amount the bondholder will be paid back on a certain date in the future, called the maturity date. As an investor nears in on a financial goal such as retirement or buying a house, they might increase their position in bonds to reduce risk. There are high-yield or “junk” bonds, which carry higher risk with a potential of earning returns close to those of the stock. Your advisor will look at factors like your time horizon and risk tolerance to determine which are appropriate for you.
Cash is the ‘safest’ investment but also offers the lowest (and sometimes even negative) returns due to inflation. The probability of losing money is this asset class is extremely low, which makes cash great for short term goals (less than a year into the future). Cash does come with inflation risk (also called purchasing power risk) because it essentially loses value each year as more is printed – making the “return” negative over long periods of time.
Asset Allocation in Action:
Rebalancing is the process of realigning the weightings of a portfolio of assets. Your advisor’s job is to determine what percentage of your overall portfolio should be invested in various instruments or sectors of the market that are aligned with your goals to achieve an expected return. As the market moves and certain sectors do better than others, the weightings are skewed from their original targets. A rebalance involves selling a portion of the investments that did well and purchasing into those that are cheap to buy to return the portfolio to its original allocation. As this is done over time, the return will be closer to what is expected, rather than investing once and not making readjustments.