Asset allocation is a time-tested strategy that can help you reduce risk by spreading your money among many different kinds of investments, such as stocks, bonds, and short-term investments. Diversified portfolios tend to provide less volatile returns over the long term and can help minimize downside risk.
In addition to balancing your overall portfolio, it is important to diversify within each investment asset class. In the case of fixed income, bond funds (or money market funds, for short term needs) invest in multiple individual securities that can provide asset class diversification. By diversifying within an asset class, you can mitigate your risk and are less likely to be affected by the performance of one single investment.
Source: Ibbotson, June, 2002
Note: Tech Heavy = 50% S&P 500/50% S&P Information Technology Sector; Equity=S&P 500; Diversified=60% S&P 500/40% Lehman Brothers Government/Credit Index; Bond=Lehman Brothers Government/Credit Index
Past performance is no guarantee of future results. Performance of an index is not illustrative of any particular investment and an investment cannot be made in an index.
Diversification does not insure a profit or guarantee against loss in declining markets.
The diversified portfolio had a smoother ride than the tech-heavy and equity portfolios. Note: Under certain unique economic conditions a portfolio of 100% bonds may outperform both a diversified and equity portfolio. However, performance of any one asset class cannot be predicted over an extended period of time.
A diversified portfolio often has its investments divided over three asset classes:
Stocks represent the most aggressive portion of your portfolio. Stocks provide the opportunity for higher growth over the long-term. But this greater potential reward carries a greater risk, particularly in the short-term, because market volatility may mean your investment is worth less when you sell it.
Bonds provide regular income and lower volatility (relative to stocks) and can act as a cushion against the unpredictable ups and downs of the stock market. Often, bonds do not move in the same direction as stocks. Investors who are more concerned about safety rather than growth often allocate more of their portfolio toward US Government or insured bond investments rather than stocks.
Short-term investments include money market funds* and short-term certificates of deposit. Money market funds provide you easy access to your money. They are considered conservative investments and offer stability of principal, but they usually have lower returns compared to bond funds or individual bonds.
* An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Interest Rate Risk
Deciding how to allocate your investments across the three asset classes – stocks, bonds, and short-term investments – will depend on your investment goals.
In general, the amount of time you have until you need the money you are investing will help determine your asset allocation and your risk tolerance. The graphics to the right depict several examples of asset allocation models. Each of the four target asset mixes has a different mix of investments, so each will strike a different balance between risk and return potential.
For an investor who has a longer time horizon and is willing to take on additional risk in pursuit of long-term growth, a higher weighting in stocks may be appropriate (i.e., growth portfolio). Keep in mind that even the most aggressive asset allocation model has a fixed income component to help reduce the overall volatility of the portfolio.
As you get closer to your goal, you may want to shift your investments into more conservative securities, like fixed income mutual funds or certain individual bonds such as Treasury bonds. Adding more conservative fixed income investments to a portfolio can help to modulate potential ups and downs found in equity investments.
In retirement, a good portion of your portfolio should be in stable, income-producing investments, but you should also continue to invest for appreciation to combat inflation.
Note: The asset allocation models are used for illustrative purposes only.
Regardless of the asset allocation model that you choose, a diversified portfolio can help ensure success in meeting your future goals. A well thought-out plan is critical: your money is too important to invest without a plan.
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Any fixed income security sold prior to maturity may be subject to substantial gain or loss. Income from municipal bonds is free from federal, and in many cases, state and local taxes but may be subject to the Federal Alternative Minimum Tax. Tax-free bonds may not be appropriate for IRA or other tax-deferred retirement accounts.
