Sticking with your chosen asset allocation mix over time can be difficult, since it often seems to go against common sense. Who wants to sell when the stock market is booming, or buy when it seems to be on its way down? One solution may be to rebalance only when one asset class exceeds the allocation you’ve assigned to it by 15%. Using such a benchmark can help reduce the stress of wondering whether or not to make portfolio changes and cut trading costs too.
And remember that changes in your personal life, or a major change in your financial goals, may call for a revised asset allocation. Adopting a baby, for example, might mean you want to put new emphasis on building a college savings account. Or taking an early retirement may accelerate your need for regular income.
The other part of controlling risk is called diversification. Since there’s no one perfect investment, your goal is to invest in a combination of individual investments across the asset classes that complement your objectives and risk tolerance. For example, you might soften the risk of investing in an aggressive-growth mutual fund by putting some money into a blue-chip fund. The first mutual fund may keep you well ahead of inflation but can expose you to intense volatility at times. The second is more likely to protect your principal but probably won’t grow rapidly in value.
There are some guidelines to keep in mind as you begin to allocate your portfolio.
- Growth. You’ll want to stay ahead of inflation with investments that increase in value over time. Stocks, stock funds, and real estate are typical growth investments.
- Income. You may need regular income from your investments, especially if you’re retired. Bonds, bond funds, and CDs are typical income investments.
- Liquidity. You never know when you might need cash quickly. In case of an emergency, you want to have some liquid investments, such as money market funds and short-term CDs.
- Risk. There’s no such thing as a risk-free investment. Higher growth and income come with more volatility and the risk of losing your principal. Higher liquidity comes with the risk of falling behind the rate of inflation. Owning a number of investments with different types of risk can help protect you from losing out on any one of them.