Determining how to allocate your investments

Asset allocation is an investment term referring to the percentage of money you should put in various asset classes such as stocks, bonds, or cash.

Within each broad asset class there are multiple subclasses of assets. For instance you could invest in the stocks of large, medium or small size companies and you could invest in the stocks of foreign or domestic companies.

Using the right asset allocation mix can potentially lower your investment risk and increase your returns, and your asset allocation decision is one of the most important you can make. In fact, research indicates that asset allocation is the primary determinant of a portfolio’s return variability, with security selection and market-timing playing minor roles.

So how should you allocate your investments? The two most important considerations are your time horizon and your risk tolerance.

Time horizon refers to your age, and how many years you have to invest before you need the money. An old adage says that greater risk equals greater reward, and investments with higher volatility (i.e. more dramatic price swings) have a higher expected return over long time periods. However, these investments also have the potential to lose money, especially over short periods of time.

A long time horizon allows you to bear some risk in your investments because of your ability to ride out potential fluctuations by holding your investments through an entire market cycle. Investment risk lessens over a longer time horizon and stocks have been the best performers over time, easily outpacing inflation and other common types of investments.

Each investor has a different comfort level with risk and will react to market fluctuations in a variety of ways. If you see a sudden market drop of 20 percent as an opportunity to buy more stocks, you have a high risk tolerance. If the very idea of losing 20 percent of your retirement account keeps you up at night, you have a lower risk tolerance. The lower your risk tolerance, the more weighted your portfolio might be towards bonds and cash.

Your financial professional can help you determine what mix of assets best suits your unique situation.

Another important factor in asset allocation is the need for rebalancing a portfolio. Too often investors overlook this critical factor. The need for rebalancing arises from the fact that stock and bond values don’t move in a straight line.

Stocks and bonds are not likely to perform the same over any given market cycle and some sub-classes of stocks and bonds will perform better than others. Left alone, your portfolio can stray far from your original asset allocation. And if it does, you take on either more, or less, risk than you had originally intended.

By regularly “rebalancing” or shifting your money among investments in order to maintain your target allocations, your portfolio is more likely to maintain a consistent risk profile.

Rebalancing has another potential benefit. Although rebalancing is not a market timing strategy, its very nature can force you to move money from an asset class that has performed well (selling high) into an asset class that has performed poorly (buying low). This strategy may provide attractive returns over time and reduce the overall volatility of your portfolio.

Asset allocation and rebalancing add discipline to the investment process, something most investors need. Before establishing an asset allocation program, make sure you understand all of the implications. An opinion from a source that isn’t emotionally involved in the decision, like a financial professional, can be a great help.

Bryan Hickingbottom, Financial Advisor, Raymond James Financial Services, Inc., member FINRA/SIPC in Lodi. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc. Any opinions are those of Bryan Hickingbottom and not necessarily Raymond James. This material is being provided for informational purposes only and does not constitute a recommendation. All investing involves risk. Diversification and asset allocation do not ensure a profit and protect against a loss.