An investing strategy designed to reduce risk by combining a variety of investments (such as stocks, bonds, and real estate). Having a variety of investments makes it less likely that all of them will move up and down at the same time or at the same rate. In a portfolio of stocks, diversification means reducing the risk of any individual stock by holding stock in a variety of companies. Mutual funds offer one way to diversify if you choose funds that represent a variety of industries and companies.
Asset allocation means investing in different broad categories (or “classes”) of investments. The three major classes in the investment markets are stocks, bonds and cash. Each of these performs differently in response to market changes. When deciding what percentage of each to hold in your portfolio it’s important to consider your financial goals, investment time frame and tolerance for market risk. According to some financial advisors, asset allocation can account for roughly 90% of the variability in an investment portfolio’s performance. To determine the right asset allocation for you, you need to consider factors such as your financial goals, your tolerance for risk, and your investing time horizon. Discuss these factors with your investment advisor. Adjust your asset allocation strategy annually or when your personal circumstances or financial goals change.
Because investment values tend to rise and fall, the percentages you have allocated to specific asset classes (stocks, bonds, cash) may not remain consistent with your original intentions over time. Be sure to review your investments against your target asset allocation at least annually. For example: Assume you started with an asset allocation of 50% bonds and 50% stocks. If your stocks have consistently increased in value during the last five years but the value of your bonds have remained flat, you may find that your stocks have grown to represent 70% of your portfolio. To maintain your original asset allocation, you may wish to sell some stock, and purchase additional bonds to achieve a 50%-50% split.
This is a technique that can help soften the effect of market ups and downs on your portfolio and take much of the emotion and guesswork out of investing. You invest a set amount of money on a regular basis over a long period of time, regardless of what the price of the investment is. When the value of the investment is up, you buy fewer shares; when the value of the investment is down, you buy more shares. The result is that you will acquire most of the shares at a below-average cost per share.