WHEN INVESTING IS VERY IMPORTANT FOR YOUR FINANCIAL FREEDOM
Whether you believe it or not, asset allocation is vital for determining your financial freedom. Get it right and you will be rewarded handsomely with a profit producing portfolio. Get it wrong and you will be spinning your wheels while financial freedom will continue to elude you. All the different securities that a person could invest in are all collectively called assets or asset classes. As your savings increases, you will be purchasing more and more of these assets over time. So then the question becomes, exactly what asset classes are you going to purchase.
A very general rule of thumb here is to subtract your age from 100, and the answer represents what percent you will devote (allocate) to stocks (equities). The balance would then be allocated to bonds. So if you were just starting out in the investing world and you are 30 years old, you would allocate 70 percent of your portfolio to stocks and 30 percent to bonds. Simply put, this would be your asset allocation.
This 70-30 mix is not perfect though because usually you should leave a small portion of cash in your investing account to be able to take advantage of good opportunities that pop up from time to time in the marketplace. Maybe you want 5% in cash or 10% at most. Therefore, the final mix would look like this: 65% stocks, 30% bonds, 5% cash. Or 60% stocks, 30% bonds, 10% cash.
If, on the other hand, you are nearing your retirement years, say you are 55 years old, then your asset allocation should be 45% equities (100 – 55) and 55% on bonds. The idea is to put greater stability to your nest egg by cutting down your portfolio’s exposure to the more volatile equities and shifting the weight in favor of the more stable bond issues. This is a form of asset allocation. You get the idea.
Asset allocation, like diversification, is an investment strategy that aims to balance the level of risk of a portfolio against the expected rewards. This is done by distributing available capital among different types of asset classes, while at the same time apportioning each asset according to targeted allocation percentages that suits the individual investor’s risk tolerance, investment objectives, and the individual’s set investment time frame.
From the previous chapter, we’ve learned that diversification is a strategy that aims to reduce the risk of an investment portfolio by distributing available capital among a larger number of different asset holdings. This time, we look at asset allocation as another strategy aiming to achieve the same goal of reducing investment risks.
Note that asset allocation employs a different approach. Instead of simply spreading the risk thinly among a large number of different assets, asset allocation reduces the risk thinly by distributing the investment among different classes of assets that are not closely related to each other.
An example of this type of distribution is a single portfolio that contains foreign stocks and domestic bonds – both of which belong to different categories of financial assets. The idea is to soften the impact of a possible price slide that may affect only one or two different classes of assets in particular. If one or two classes of assets decline, then the others will remain unaffected and will continue to make gains.
You may have heard that historically speaking stocks have a better rate of return than bonds. So then why not just put all your investment money into stocks? While that is a good deduction, the answer is also of a historical nature, and that is as follows: different asset classes perform differently in response to changing economic events and market factors.
A simple example of this can be seen when stocks are falling, bonds tend to rise as investors see them as a haven and flee from stocks and move into bonds. If you would like to achieve true financial freedom one day, then it would behoove you to invest across several different asset classes.
There are many other classes of investments that are not so correlated to equities which you may consider for inclusion in your asset allocation strategy. They include real estate, precious metals, rare and high valued collectibles, and financial derivatives, to name a few. Others even divide the equities market into different categories and consider each as a sub class where they apportion their investments in line with the concept of asset allocation – as long as they are not so correlated with each other.
For example, there are those who divide equities based on the size and market capitalization of the company issuing the shares of stocks; others prefer to segregate equities according to the industry sector or group to which the issuing company belongs such as technology, exchange traded funds, retail, mining, healthcare, food, utility, etc.; others divide equities according to their growth rate within the most immediate past, their current value in the spot market, and even the income earned in previous years; others have a more general classification, separating local equities from those that are foreign issued.
In simple words, asset allocation refers to the investment strategy used by investors to apportion their investments among the different classes of financial assets. It is a crucial component of financial planning that aims to streamline investment portfolio in order to maximize returns for a particular level of risk.
The level of risk varies from one investor to another, depending on several factors like the individual’s appetite for risk (risk tolerance), how long he intends to hold on to the portfolio (investment horizon), and his investment objectives and targeted goals.
As in our 70-30 principle, the younger the investor is, the bigger his risk tolerance is since he can hold on to his portfolio for a longer period of time. He is likely to have a more aggressive portfolio mix that is heavy on equities. Conversely, the more matured investors would be more interested in keeping their savings and their earnings intact as they approach their golden years. These investors are more likely to play it safe and veer more towards conservative portfolios that are heavy on bonds.
Asset allocation has a deeper and more profound effect on the returns that are expected to be generated by an investment portfolio – much more than the actual selection of assets to include in the portfolio, or the timing of the execution of trades. Studies have shown that 97% of the returns made by profitable portfolios can be credited to having the right asset allocation strategy.
Furthermore, purchasing different asset classes adds to the diversity of your portfolio and as everyone knows, you don’t want to put all your eggs in one basket. More advanced investors would be spreading their assets over a larger mix of asset classes. For instance, one could purchase commodities, futures, options, etc. as a small percentage of your entire portfolio. Your Asset Allocation might look like this: 25% Domestic Equities (stocks), 25% Foreign Equities, 10% Corporate Bonds, 10% Government Bonds, 10% Municipal Bonds, 5% Commodities, 5% Precious Metals, and 10% Cash.
The last piece of the asset allocation puzzle involves a concept known as time horizon. When you are just starting out investing, you have a long time horizon. In other words, you won’t need the money back real soon. As you get closer to your time horizon, you need to shift your asset allocation from an aggressive position to a position that does not have as much exposure to risk.
This is because of the possibility of a market downturn will leave you with not much time left to recoup your losses until you need the funds back for retirement. You accomplish this by shifting your asset allocation from one that is mostly stocked to one that is bonded. In our earlier example of 60-30-10 (stocks, bonds cash), you would reverse it over time so that by your retirement date, the portfolio would be 60% bonds, 30% stocks, and 10% cash. Your financial freedom will be dependent upon it so be sure to get this right!