If you’re like most people, you don’t know all of the ins and outs of how investments work. You have an understanding, but the finer details are still a little unclear. Fortunately, that’s not a problem. There’s no need to dive into how it all works and learn an entirely new trade. What you do need to know, is how asset allocation models work. This will allow you to pick the right investments that fit your goals.
Determining risk tolerance
Finding the right asset allocation model for you starts with understanding just how much risk you want to take on. Two categories make up that risk: time horizon and risk tolerance.
Time horizon – Simply put, how long will it be before you need the money you’re investing? Socking away money for a new car in five years will require you to invest more safely than putting away for retirement 20 or 30 years from now. Longer time horizons mean more opportunity to recover from a market downturn.
Risk tolerance – Your time horizon determines a good portion of your risk, but how much risk you actually feel comfortable taking determines the rest. Investing without emotional attachment is best, but we are emotional beings.
Understanding risk and reward
Generally speaking the more risk you take, the greater the potential reward. So investing heavily in startup companies has the potential for a huge return on your investment. It also carries the big risk that they may fail.
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When you look at asset allocation models, you will see that a portfolio that is allocated toward equities instead of bonds. But if you’re very risk-averse, a portfolio of nothing but bonds likely still isn’t in your best interest since history shows that you will take the same risk for a lower return.
Choosing the right asset allocation models
Asset allocation models can be broken down into as many categories as you would like, but most often they are divided into five based on how much risk you want to take.
Very conservative
The very conservative allocation is for those who no longer want to grow their wealth. Instead, their goal is the preservation of wealth. For those who are about to retire, or retired, a very conservative allocation will help to reduce their risk of losing money during a recession. Often these models are 90 percent bonds or more.
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Conservative
A conservative asset allocation model takes on a little more risk. The goal here is to preserve most of the wealth, but take some risk to capture gains before the money is needed. For investors that are approaching retirement, the conservative allocation helps to minimize their risk. A conservative allocation is often 80 percent bonds and 20 percent stocks.
Moderate
A big bulk of investors will fall into the moderate allocation. Here they take some risk in order to continue receiving a rate of return that will allow their portfolios to grow. But they balance that out with bonds to offset any potential losses during a market downturn. Those in the middle of their careers are best served with moderate asset allocation models made up of 40-60 percent bonds and 40-60 percent stocks.
Aggressive
If you have a long time horizon (20 or more years) an aggressive portfolio is probably right for you. There is plenty of time to recover from market downturns, and the risk taken now should provide a considerable rate of return to see lots of growth in the early part of your career. Most aggressive portfolios are about 20 percent bonds and 80 percent stocks.
Very aggressive
When you’re just starting your career, or you have a considerably long time horizon before you need to take a withdrawal, the very aggressive portfolio is used. This allocation is designed to provide big growth now so that you have a substantial base to draw on later. While a recession can wipe out a lot of the value, the long time horizon means you can recover without worries. Most of these portfolios are made up of at least 90 percent stocks, and often 100 percent stocks.
Which of the asset allocation models is right for you?
Asset allocation models can seem intimidating, but really it’s just allocating your dollars to the right places so that you take the risk you’re willing to take. If you’re working with a financial advisor, they should be helping you to re-evaluate your risk on a regular basis. This will ensure your portfolio is invested the way you want. Those meetings can be further apart at the early part of your career. But as you approach retirement they get closer together.
If you manage your own investments, there are many different programs that you can use to determine what risk you’re taking so you can rebalance as needed. You simply plug in the funds you have and their amounts, and the software does the work for you.
