Whether your retirement is years away or right around the corner, your investment portfolio should be designed with your financial goals in mind. It needs to be forward-thinking enough to handle the whims of the market but flexible enough to make changes on the fly.
One of the most important concepts for any investor to understand is asset allocation. Put simply, asset allocation describes the division of stocks, bonds, alternatives, and cash that make up your investment portfolio. Although this concept is straightforward, it has a profound impact on your financial future.
Each asset class has its own set of risks and rewards, depending on your time horizon and financial goals. You and your financial professional may make adjustments to your portfolio over the years as your needs change.
- Stocks, also called equities, allow you to own a share of a publicly traded company. By investing in stocks, you have the potential for a higher return on your investment. However, if the company performs poorly, or if the economy takes an unexpected turn [for the worse], you may also lose money.1
- Bonds, overall, have been a steadier source of fixed income. However, bonds are subject to interest rates and inflation risks, and their rate of return tends to be lower.1 For example, at the time of this writing, interest rates increased rapidly due to the higher inflation in the marketplace and the Fed’s hawkish stance to tighten monetary policy.2 Bond yields and bond prices have inverse relationship, thus when the interest rate increases, bond prices fall. As a result of that relationship and the rising rate environment, bond investors have experienced losses this year.
- Mutual funds are pools of multiple securities in which you can invest. While many mutual funds have a mix of stocks and bonds, some specialize in specific asset classes. Mutual funds may offer less risk than investing directly in stocks, as diversifying your asset allocation tends to spread the risk.1 However, it is important to look under the hood to ensure the investment quality and strategy of the mutual fund are desirable. Also, mutual funds can be open-ended or close-ended. Open-ended mutual funds are the most common type of mutual fund. Shares of open-end funds are bought and sold directly from the fund at a price per share that is based on the value of the fund’s underlying securities. On each trading day, typically at the end of the day, the net asset value (NAV) is calculated by dividing the market value of the fund’s assets (less expenses) by the number of shares held by investors. Close-ended funds are generally actively managed and don’t track an index. They also have a fixed number of shares and are traded on exchanges among investors. Although the close-end fund value is also based on the fund’s NAV, the actual price of the fund is determined by supply and demand, so it can trade at prices above or below the value of its holdings.3
- Exchange-traded funds (ETF’s), similar to mutual funds, ETF’s are also pools of securities that allow investors to track a specific index or basket of goods. You can buy and sell ETFs during market hours. Many ETFs have lower fees than their mutual fund counterparts. They are usually more tax efficient than mutual funds, as taxes are not passed through when the portfolio manager buys and sells the underlying securities.4
- Alternative Investments could be liquid Real Estate such as REITs, Commodities or Hedge Funds. These are asset classes that perform differently when compared to equites and fixed income instruments; therefore, they can be used to diversify away risk and enhance returns. REITs tend to be correlated to equities while commodities and hedge funds tend to have lower correlation to the performance of the equity markets. Both Commodities and Hedge Funds have the potential to enhance portfolio returns due to their low or inverse correlation to the equity markets. Hedge funds with low but steady returns tend to be a good addition to any long term investment portfolio.
- Cash and cash equivalents can provide flexibility for any unexpected emergencies that may arise. If encountered with an unexpected expense, having readily available cash and/or cash equivalents can negate having to take on new debt to cover the cost of the expense, which could adversely affect future cash flows. However, cash typically cannot provide yields similar to that of other investments, this is particularly true during high inflationary times like we are currently experiencing, where cash effectively loses future buying power.1
Finding A Balance
When it comes to managing your portfolio, asset allocation requires a more hands-on approach. “Setting it and forgetting it” may sound appealing, but changes in the market warrant a portfolio review to make sure your asset allocation still makes sense. Working with a financial professional is a great way to make sure that your asset allocation reflects your goals, and they can help make adjustments to any changes that life throws your way.1
This content may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.