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We welcome the New Year with a new segment here on Breakout, called Investing 101. It's designed to demystify the daunting world of investing and crack the code on the language and jargon of Wall Street. We hope it's fun, helpful and inspirational for investors of all levels of experience.
If you were setting out to bake a cake, the first thing you would need to do is figure out what kind you wanted and then put together a list of ingredients. The same is true when building your own portfolio.
Before picking your ingredients, you need to first determine your objective (what you want your investments to do) and your risk tolerance (how you'd like the journey go). Once you have done that, the fun part is putting together the right ingredients.
Generally speaking, the most portfolios contain a mix of 3 asset classes: Stocks, bonds, and cash. You are free to add as much or as little of each as you'd like. The resulting mix is known as your asset allocation and it is typically expressed in percentage terms and frequently displayed as a pie chart.
"There's a lot an investor needs to think about when they figure out how much to put into the different slices of the pie," says Jim Randel, author of Money: Get It, Guard It, Grow It. He pinpoints factors such as age, retirement aspirations, available income and savings.
There are countless asset allocation calculators available for free on the internet to help you determine the right blend for your personal situation. Once you have established your base allocation or mix of assets (e.g. 75% stocks, 20% bonds, 5% cash) it's time to put your formula to work!
Say you had $1,000 to invest each month, and your allocation was 75/20/5, you would be adding $750 a month to your stocks, $200 to your bonds, with the rest going in to cash.
As more money is added over time, and your various investments change in value, you will need to periodically make adjustments to stay within your original allocation figures. It is a process known as rebalancing. Randel recommends doing this at least once or twice or a year, and then even more frequently as your portfolio gets larger and more complex. But keep in mind, as your investments grow, you will also need to do a second level of allocating or sub-allocating.
What this means is, if you have a $10,000 portfolio that is supposed to be 75% invested in stocks, you will need to determine how to divide that chunk of the pie up. In this case, you could divide $7500 evenly between 3 different types of stocks or stock fund, e.g. $2500 into a small cap fund, $2500 in an emerging markets fund and $2500 in a technology sector.
Says Randel; "How you allocate within an asset class is as important as how you allocate between asset classes."
As I said, the more money that you have invested, the more often you will need to rebalance your funds. Most experts say do it at least once or twice a year, and says the New Year is a perfect opportunity to do so.
He thinks investors need to consider at least 3 areas when carving up their assets including:
- a changing world view
- personal life changes or situation (job, divorce, baby etc)
- part of a healthy routine (don't leave it to chance)
So there you have it; a quick look at asset allocation, sub-allocation, and re-balancing. Good luck and let us know below if there is a topic you would like discussed in our next Investing 101 in the comment section below or on Twitter @MattNesto
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