This is the fourth step in our complete series of Getting Started Investing. If you’re a beginner who’s looking to make your first investment and build wealth for the future, then read on.
Before diving into how to create proper asset allocation, let’s discuss what it actually is. Asset allocation is a strategy that involves building a portfolio around asset classes — including stocks, bonds, cash, real estate, and other investments.
Nothing affects your long-term returns more than good asset allocation plan. To see that I practice what I preach, check out my personal allocation strategy, Asset Allocation for Retirement.
DIY, Robo Advisor, or Professional?
As mentioned, a properly set up retirement nest egg is made up of a combination of stocks, bonds, commodities, real estate, and cash. You’ll need to setup your asset allocation to reflect your risk tolerance, financial goals, and timeline.
Another strategy to consider is tactical asset allocation or TAA. TAA involves active portfolio management by rebalancing the percentages of assets based on current economic conditions. For example; let’s say stocks take a plunge. You may want to temporarily rebalance your portfolio to focus on stocks. Why? Buy low, sell high. When everyone is scared, there are deals to be had.
But before tackling asset allocation, it’s important to understand that your situation is slightly different than anyone else’s. So you must first decide on whether you want to DIY your own asset allocation, hire a professional advisor, or use a robo advisor service to do it for you at an affordable price.
Doing It Yourself – Obviously, the benefits to handling your own asset allocation allows you to save some money on paying professional fees and expenses. The downside is that you might not be updated enough on the goings-on of the stock market to choose the best diversification strategy for your personal needs.
Using a Robo Advisor – As a sort of middle-of-the-road option, a robo advisor, (such as Betterment) will choose a preset allocation strategy for you, based on your risk profile. This allows you to feel confident in your decision without paying a ton of fees.
Hiring a Financial Advisor – A professional can help pin point the best allocation for your current situation and investment goals. However, they will be a bit pricier than if you tried tackling it yourself.
Type of Assets
The question is: what should you be investing in? A good place to start is with mutual funds and/or ETFs. These funds allow easy diversification without the possibly complicated process of stock picking. For most individuals ETFs are usually the better choice. Though let’s discuss the differences between the two:
Mutual funds are collections of investments and can be either open-end or close-end funds. Open-end funds are purchased directly from the fund manager. Their values are determined daily and there isn’t a limit on how many shares are issued. Close-end funds have a limited number of shares and the NAV does not determine the price.
When a mutual fund is sold, the fund has to sell shares to pay the investor. Usually this will cause a capital gain that must be distributed to shareholders.This mutual fund turnover could result in higher taxes for you.
ETFs, or Exchange Traded Funds, are made up of units of underlying investments. There are three main types: Exchange Traded Open End Index Mutual Funds, Exchange Traded Unit Investment Trusts, and Exchange Traded Grantor Trusts.
- Exchange Traded Open End Index Mutual Fund: Connected to an index, dividends are reinvested when received, and paid to shareholders quarterly.
- Exchange Traded Unit Investment Trust: Required to fully replicate the designated index. Dividends aren’t reinvested automatically but they are still paid out quarterly.
- Exchange Traded Grantor Trust: Investor owns the underlying investments.
Unlike mutual funds, there is no need to sell when an investor wants to redeem shares. Therefore, capital gains tax isn’t generally a problem due to fund turnover. ETFs also offer the possibility of arbitrage.
For more information about these funds, read Mutual Funds vs. ETFs.
If you are interested in branching outside the “stocks/bonds/mutual funds/ETF” routine, consider alternative investments. Different options you can explore include:
- P2P investing through Prosper or Lending Club
- Master Limited Partnership (MLP)
- Real Estate Investment Trusts (REITs)
- Ginnie Mae Bonds
- Commodities – Gold and Silver
Interested in one of these alternative investments? Read Alternative Investments for more details about each! The rebel in you will be thrilled.
Diversify Your Portfolio
Every investment guru and their grandma will tell you that it’s incredibly important to diversify your portfolio. Why? By spreading your money over several asset classes, you are less likely to lose it all, should the market tank.
We all get the basic principles of “don’t put your eggs in one basket right”? Great! Check out this article on doing the same thing with your business, How To Manage Risk? Diversify!.
Unfortunately, when it comes to investing, diversification may not be as easy as you thought. Whether you are accidentally under-diversifying or even OVER-diversifying, diversification can be tricky! Here’s why:
Asset Classes Aren’t Mutually Exclusive
Aggressive investors invest heavily in stocks. While they might have great diversification in stocks, their entire portfolio can take a nosedive when the market is down. Below is a complete list of the types of asset classes you can invest in.
Traditional Asset Classes
- Stocks — including value, dividend, growth, and preferred, as well as small-, medium-, and large-cap, domestic, foreign, and emerging
- Bonds — including junk, investment-grade, government, corporate, short-term, intermediate, and long term, as well as domestic, foreign, and emerging
- Cash — and cash equivalents
Alternative Asset Classes
- Commodities — including precious metals, agriculture, and energy
- Real estate — including commercial, residential, and REITs
- Collectibles — including art, coins, stamps, classic cars, and vintage wine
- Foreign currency
- Insurance products — including life insurance and annuities
- Derivatives — including options, futures, and collateralized debt
- Venture capital
- Private equity
- Distressed securities
Here are some important factors to remember when creating your ideal asset allocation strategy:
Humans are emotional – It’s easy to invest when the market is good and really hard to invest when it’s not. When emotions come into play, you are likely to lean too far one way or another because it feels right.
Don’t be afraid of what you don’t know – By only sticking to stocks and bonds, you could miss out on some great investments. Educate yourself so you don’t miss out on these opportunities.
Investments aren’t scripted – Diversification will not protect your portfolio when all the asset classes tank at the same time like we saw during the financial crisis of 2007-08. That’s a big part of the game that people have problems with.
Avoid too many accounts – Managing multiple accounts can easily confuse you and cause you to forget to diversify one or more of them.
Be careful of diversification overkill – If you are diversifying your assets too much, you are likely missing out on potential gains and paying too much in transaction fees. The key is balance.
If I haven’t scared you too much yet, check out 6 Reasons Why Diversification Can Be Tricky for more information on the subject.