If you’ve ever been caught in heavy traffic, you know how it always seems to go: you’re surrounded by hundreds of cars trying to get to the same place that you are; your lane isn’t going anywhere, and everyone around you seems to be moving along just fine. Until you switch lanes, that is. That’s when your old lane starts to move forward and your new lane grinds to a halt. Sound familiar?
These days, navigating the financial markets is a lot like being stuck in heavy traffic. You have your money invested in a traditionally strong asset class-real estate or common stocks for example-but it doesn’t seem to be going anywhere. So, you move it into a sector of the market that seems to be enjoying better performance, and what happens? Your old asset class takes off and your new one grinds to a halt – leaving you and your asset accumulation plans going nowhere.
Switching investment strategies in response to lackluster performance – just like switching lanes in heavy traffic – carries with it a number of potential risks. Domestic and world events, changes in the economy, even bad weather can all affect what happens to your money on a day-to-day basis. There is simply no way of looking down the road to see what’s coming next and no guarantee that your new strategy will perform any better than your old one did.
So how can you get yourself out of the “slow lane” and position yourself to take better advantage of periodic upswings in more than one sector of the financial markets? For many investors, the answer is an asset allocation strategy.
Asset allocation is the practice of spreading your money among several different asset classes (e.g. stocks, bonds, mutual funds, CDs, annuities, etc.) in order to reduce your exposure to loss and increase your opportunities for growth. Portfolios that include different types of investments generally enjoy a greater degree of protection against market volatility than those that do not. For example, when stock prices rise, bond prices generally fall-and vice versa. If you’ve got money invested in both stocks and bonds, losses you suffer in one investment can potentially be offset by gains in the other.
How do you determine what kind of asset allocation mix is right for you? The answer depends largely on your tolerance for risk and investment time horizon. If you’re the kind of person who lies awake at night worrying about what the stock market is going to do, you probably have a low to moderate tolerance for risk. If you aren’t so concerned about what the markets do on a daily basis and you’re willing to take on greater levels risk in order to earn potentially larger gains, you might want to consider more aggressive investments. In either case, your asset allocation strategy should reflect your tolerance for risk.
Your investment time horizon is simply the number of years between now and when you will need access to your money. The longer your investment time horizon, the longer you will have to recover from potential losses. People with long investment time horizons are often more comfortable investing in riskier but potentially more rewarding investments. Conversely, the closer you are to needing your money, the less comfortable you may be with putting it at risk. Individuals approaching retirement, for example, generally move their money into less risky and more conservative investment vehicles.
Once you understand your tolerance for risk and investment time horizon, you will likely base your asset allocation strategy on one of four general asset allocation models: preservation of capital, income, income and growth (balanced), or growth.
Preservation of capital models are largely designed for investors who expect to need their money within a few short years-people who are unable or unwilling to put any of their principal at risk. Income models are designed for individuals who require current income. These are generally people who are at or approaching retirement or who have others depending upon them for support. Balanced models tend to strike a compromise between preservation of capital, income, and growth, and are usually comprised of an asset mix that both appreciates over time and generates current income. Balanced models are ideal for people who still have time to accumulate assets, but who don’t have a particularly high tolerance for risk. Finally, Growth models are designed for individuals with a long-term investment time horizon and a higher than average tolerance for risk. These are usually younger, working individuals who are just beginning an asset accumulation program.
Regardless of where you are in life, it’s never too late to develop an asset allocation strategy, especially if you’ve been feeling stuck in the “slow lane” when it comes to your investments. The right asset allocation mix will not only help you maintain your confidence through the stormy economic waters that may lie ahead, but it could also increase your potential for better returns over the coming years. Keep in mind, however, that neither diversification nor asset allocation ensures a profit or guarantees against loss.
You can’t drive in three lanes of traffic at once, but working with a trusted financial professional, you can get back on the road to a secure financial future.