NEW YORK (MainStreet)—When you are just starting out and you have those first few dollars to invest one question normally comes to mind: How do you build a properly allocated portfolio?
New investors sometimes find it tough even to make an initial commitment to start saving for retirement.
But it is the right and necessary thing to do...
And once you have made that commitment, and that pile of investment dollars begins to grow, investors have a different an ongoing challenge to face – how to allocate those assets properly .
Now, asset allocation is a term that is bandied about a lot. It is the second most critical step, right after the act of saving.
But how many investors, especially the newbies, really know what it means?
Let's take a quick course in asset allocation...
There are several factors to consider when investing...
As a financial advisor, I have asked seemingly rudimentary but critical questions countless times.
The first one is usually "What's your time horizon?"
It may seem obvious, and it should be, but investors often put the cart before the horse...
An unfortunately common response has been: "I don't know. I just want to make a lot of money."
Well, if you don't know your time horizon, you better figure it out, because the amount of time you have to commit to an investment dictates what type of investment will appropriate.
If you need the money next week, I wouldn't suggest you invest the money in a new tech stock that just went public...
...and if you don't need the money for 20 years, a bank savings account might be a safe place to put your money but won't earn very much.
You see, risk is the factor. Too much risk in the short term could mean you get back less than you put in...too little risk means after decades you might have no more money than you started with.
And you have to accept some risk if you want to see your investment grow...
Risk tolerance is a little tougher to quantify than time horizon but it is very important to know your own.
Whether you are DIY investor or you are someone seeking the advice of an investment professional, you need to know how you will react to losses...
...because that's what "risk tolerance" really means.
Taking a big risk can make you wealthy, but it can also leave you broke.
And as I've seen many times before, an investor may profess to have a high tolerance for risk and therefore invests in something risky...
But as soon as the invest declines in value a little bit, the investor panics and sells at a loss.
You want to avoid that type of emotional, reactive decision making. If you are the type of person that will lose sleep over small losses then you do not have a high risk tolerance and should invest accordingly.
And those two nuggets of information, time horizon and risk tolerance, go a long way toward determining what an appropriate asset allocation should look like for you...
Much of what we call asset allocation today is derived from Modern Portfolio Theory. MPT was developed in the 1950s and won some smart guys Nobel Prizes.
It was an attempt to maximize portfolio returns for a given level of risk through diversification. And by diversification, we mean "don't put all your eggs in one basket"...
And that means investing in things that are "non-correlated"; assets that aren't similar and that behave differently.
If you are a new investor with not money much to invest, it is easy to get diversified. Whether in a 401(k) or a brokerage account there are numerous mutual funds and ETFs that do the leg work for you...
Funds with names that include the words "balanced" or "asset allocation" typically are diversified across multiple asset classes...
A good starter fund will have investments in stocks (both domestic and international), bonds and cash (money markets).
This way when stocks are, down bonds will usually be up and vice versa. Owning assets that are non-correlated (that don't move up and down together) smoothes out volatility and provides for more predictable growth.
But as your nest egg grows, so will the choices of investments.
While most new investors start with mutual funds within their employer-sponsored retirement plans many will branch out into other investments like ETFs and individual stocks and bonds as they become wealthier and more experienced.
But that won't change the fundamental principle of asset allocation.
If you are a stock investor, you want to own stocks of different companies, in different industries and that are issued in different countries.
The same applies to bonds. You want to own corporate bonds and treasuries as well as municipals (for the tax free income) and foreign bonds.
You want a little of everything to avoid becoming concentrated in any asset class, sector or region.
Of course, at times there may be an opportunity to invest in a hot stock that seems like it will help you retire early...
Well, go for it; but don't get in over your head.
I've seen more people blow up their portfolios that way than retire early.
The bottom line is you must know your time horizon, be aware of your emotional ability to withstand losses and spread out the risk among many types of holdings. That way your long term plans won't get ruined by short term mistakes.
Steven P. Orlowski is a financial services industry veteran who has served in a variety of capacities including financial planner, portfolio manager and trader. He brings a wealth of hands-on experience and industry insider perspective to his analysis and commentary. In addition to being a Certified Financial Planner™ he has held the following licenses: FINRA Series 7, 9, 10, 63, and 65 and various state Life and Health Insurance licenses.