Two Keys to Optimal Investment Portfolio Growth
When it comes to the portfolio, investments, and retirement planning, the biggest dilemma faced by investors nowadays is about where they should park their money, and how much. Should they invest all their funds in bonds or completely in stocks? Or should they just buy short-term cash securities like Treasury bills? There are literally thousands of choices to go with—stocks, bonds, mutual funds, currencies, precious metals, and many more.
When an investor is unsure about where to park their money and how much to place in a certain investment type, asset allocation plays an important role. The main goal of an investor is usually to achieve higher returns with calculated risk and diversification—asset allocation provides a solution to this problem.
At the core, the concept of asset allocation is to spread the savings or investment capital across different asset classes, so if one underperforms, the other bears the load of its demise—call it diversifying a portfolio with different investment types.
Sadly, there is no magic formula that suggests how much to put in a certain type of security or what to buy, but there are guidelines that investors can follow to achieve the optimal returns.
There are two most important factors an investor must consider when it comes to asset allocation:
1. Risk Tolerance
It is true that with higher risk comes higher reward, but let’s be honest—it’s not a viable option for every investor. How about those who are planning for retirement; can they risk heavily as a person in their mid-20s? If you risk more, your portfolio will be volatile—meaning it will see wild swings in returns.
Before you go ahead and buy stocks, bonds, or other investments, you need to know how much you are willing to risk losing. Once you know your risk level, you can invest accordingly. As mentioned earlier, a person in their 20s will have a different risk level than a person in their 50s, who’s planning for retirement soon.
After you identify your risk tolerance, asset allocation becomes a bit simpler. For example, if you are willing to see volatility in your portfolio, you can focus more on riskier securities—maybe trying stocks, instead of government bonds. On the contrary, if you want to take a conservative approach, you can buy government bonds and stay away from riskier bets.
2. Portfolio Goals
Sometimes, investors might just invest for the sake of investing, without realizing what they actually want to achieve with their portfolio. The investors might want to generate income from their portfolio, or they might want to achieve certain returns in order to meet some financial goal. It is important to know the purpose of the portfolio before proper asset allocation can get underway. If the purpose of the portfolio is unknown, then the investor might suffer from losses.
As important as knowing the purpose of the portfolio is for asset allocation, investors should also know the timeframe of their action plan. This means that the investors should have a general idea of how long they are planning to manage their portfolio. For some, it can be 30 years, because they are planning to retire then; for others, it can be five years, because they are investing for their children’s education.
Once investors know their portfolio goals, they can look into securities that fit their criteria. For example, if someone wants stable income for an extended period of time, while taking the least amount of risk, then they should invest in long-term government bonds.
Why bother with asset allocation?
Asset allocation can prove to be a good investment management technique for those who are trying to balance market risk in their portfolio with diversification across different asset classes. If practiced with discipline, it can potentially provide peace of mind and a hedge against the volatility.
At the same time, while asset allocation provides the benefits of diversification, there are still some risks a portfolio holds, no matter what. If the overall market falls, it is very likely that investor’s portfolio will fall with it.