Asset Allocation: Tools of the Trade
Investment managers divide your portfolio into different types of assets. The technical term is ‘asset allocation’. Some of your investments may be in stocks, some in bonds, some in real estate, and maybe some in another special class. But the whole investment picture relates to your asset allocation.
If you direct your own investments, asset allocation is one of the first things you should consider. Some people learn this the hard way. In an effort to get rich quick, they fall into investing all their money into one asset – often stocks or real estate. Sometimes it works out. Most of the time, it works against you. Without proper asset allocation, you could lose your entire investment portfolio on a risky bet.
Even if you want to live on the interest from a million dollars, it’s important to consider wise asset allocation as soon as you start investing. But before you do that, it’s good to define the components of asset allocation. Investment managers use these categories to construct portfolios. The snapshots below explain what they are and what sort of risk to expect from each:
1) Cash or Cash Equivalents
The most common asset class is cash. Cash generally includes any cash saved above what you need from a transactional basis. This can include your savings account, your money market account, and even the physical savings bonds kept in your dresser (Note: You should always keep anywhere from 6-12 mo cash aside for emergency basis). Foreign currency is also considered a type of cash, although it’s often distinguished in asset allocation. Cash is a low-risk, low-return asset, typically used to offset some of the riskier parts of your portfolio.
2) Stocks or Equities
Stocks are shares of ownership in a company. Stocks can be subdivided in numerous ways including small-cap vs. mid-cap vs. large-cap relating to the size of the company. Sometimes they are categorized by their growth-orientation (value vs. growth). A distinction between domestic stock and international or emerging market stocks is also common. Most of the financial press is focused on stocks. Stocks historically have offered greater return opportunities but also great risk and volatility.
Bonds are debt securities. They are formal contracts that governments or companies issue to borrow money that will be repaid with interest at fixed intervals. If you’re a bondholder, you have lent your money to someone because you expect to get a stream of interest with your principal back at a later date. Bonds have traditionally offered less return than stocks over time, but also less risk and volatility.
Commodities are physical assets that are traded on the capital markets. These include corn, soybeans, gold, platinum, cotton, oil, natural gas, pork barrels, etc. Commodities are usually higher risk assets, but are especially high-risk in the leveraged futures markets. Although volatility can be very high with commodities, they are useful as an asset class that is less correlated with stocks.
5) Insurance Contracts
Insurance contracts include any annuities or life insurance. They can be considered a growth or income asset, but are generally used for eventual income planning purposes. Both kinds of contracts can be invested in fixed return or use market instruments to fuel growth. Insurance contracts also have an additional risk, since they depend on the solvency of the issuer.
There are three other types of assets that qualified investment managers can invest in: Real Estate, private businesses, and special collections. Each of these requires a different skill-set and knowledge base, but they are still legitimate assets to be considered in asset allocation.