As the old saying goes, “don’t put all your eggs in one basket.” This is very relevant to life, especially investing. Diversification is crucial for building wealth and it refers to having a portfolio with a unique mix of investments like stocks, bonds, ETFs, real estate, and more. You can further diversify by segregating your stock or ETF investments by sectors and size (i.e. market cap).
Below, you’ll learn about three simple ways to achieve optimal asset allocation so that you can grow your wealth while weathering any storm.
Develop your risk tolerance
Risk tolerance is a key component behind any sound optimal asset allocation strategy. This refers to how much risk you can stomach during various market conditions. Every investment firm has slightly different risk tolerance categories, but the main three categories are Conservative, Moderate, and Aggressive.
Conservative investors are uneasy with market volatility and are more tempted to panic sell. Panic selling occurs when markets decrease substantially and investors sell at a loss. Many conservative investors choose to give up the possibility of higher returns in exchange for safety.
They’d be more likely to invest most of their capital in Treasury bills, Investment-grade bonds (a.k.a fixed income), money market accounts, certificates of deposits (i.e CDs). An example conservative portfolio could have 50% US investment grade fixed income, 30% CDs, and 20% cash.
These investment choices are more liquid and less susceptible to large losses compared to stocks. Conservative investments can provide relatively steady sources of income via interest payments.
Moderate investors can handle some market volatility, but they want a buffer with conservative investments. A hypothetical moderate portfolio might be 50% large-cap stocks, 40% investment-grade bonds, 10% cash/money market investments. This investor type can also benefit from the higher returns that stocks or equities can produce. Moderate investors can build their wealth via price appreciation (especially with stocks) along with dividend and interest payments.
Aggressive investors are fine with market volatility and can remain calm even when their portfolios drop by 20% or more. Many of these investors have more knowledge than the typical person and choose to invest in riskier assets. Some of these riskier assets include small-cap stocks, options, currencies (Forex), cryptocurrency, and even hedge funds. A sample aggressive portfolio might be 50% US large-cap stocks, 20% small-cap stocks, 20% in options/cryptocurrency, and 10% in cash.
Some ultra-aggressive investors study the markets and different types of investments every day. They have detailed technical knowledge and use tools like algorithm-based trading software for high-risk practices like day trading stocks or currencies.
Understand your goals and time horizons
Goals are a key component of financial planning, life, and determining your optimal asset allocation. Every goal like buying a house, saving for a vacation, or even saving for retirement has a different time horizon. For example, saving for a $3,000 vacation might be a two-year goal. Conversely, planning for retirement could have a time horizon of 30 years!
So, be sure to consider each goal’s time horizon and your risk tolerance for each one prior to constructing a portfolio. If you’re looking to buy a house in 3-5 years, it might be prudent to focus on conservative investments like high yield savings accounts, CDs, and short term, investment-grade bonds.
Investment-grade bonds are offered by companies that have an S&P BBB-rating or higher, which means that they have a low risk of default. These bonds can also pay you a consistent interest income that might be higher than the yield on a savings account.
Some longer time horizon goals include saving for retirement or your child’s college education. It’s likely that you won’t withdraw these monies for decades. So, it might make sense to invest them in riskier assets that have higher return potential like stocks, mutual funds, ETFs or long term alternative assets like real estate. While these investments are riskier than CDs or bonds; they aren’t as volatile as forex or cryptocurrency.
Many long term investors use index funds as part of their optimal asset allocation, which tracks the performance of market indexes like the S&P 500. Index funds invest in hundreds of companies and have minimal costs since they aren’t actively managed by a portfolio manager. Other types of fund vehicles available are alternative asset funds like DiversyFund’s Growth REIT, which provides investors with access to a curated portfolio of private real estate assets.
Know fundamental metrics
Beta: Beta refers to how volatile an investment is compared to its benchmark. A beta of 1 means that the investment has the same volatility of its benchmark. A beta of 0.5 shows that it’s half as volatile and a beta of 2 means that it’s twice as volatile. You can use beta as a foundation for your optimal asset allocation.
Correlation: Correlation is a way to see if two assets perform similarly during certain markets. Some assets like precious metals (i.e gold) can have high returns during periods of inflation, while most bonds suffer during this time. So, gold and bonds are inversely correlated, meaning that the one provides better returns when the other decreases and vice versa. Having inversely correlated assets can help your portfolio see some gains in various situations.
It’s imperative to diversify your investments as this will prevent you from having excessive risk. Having proper asset allocation will also prevent the damage from having too much capital in one stock, fund, or other investment. Failing to do this could result in losing thousands, if not your entire savings as seen with many Enron shareholders.
Luckily, it’s feasible to achieve your optimal asset allocation by understanding your risk tolerance, goals, time horizons, and fundamental metrics like correlation.