While the primary goal of investing is to make money, it’s difficult to predict how those investments will fare. Investment vehicles, such as stocks, bonds and the equity market, are highly volatile. Even the financial gurus cannot guarantee which investment will deliver the best results. To minimize those risks and maximize your return, you should distribute your assets among several different asset classes. This is often referred to as asset allocation.
What is Asset Allocation?
Asset allocation is a financial strategy to diversify your hard-earned money into different types of investments. There may be as many as eight-ten different asset classes in a well diversified portfolio. Some of the different classes include money market accounts, U.S. equities, international equities, U.S. bonds, U.S. corporate bonds, U.S. government agencies, natural resources and commodities.
The primary aim of asset allocation is to reduce the level of risks and ensure healthy returns. An asset allocation strategy offers good returns due to the fact that different investment instruments will offer varying returns at different points in time. For example, stocks are considered to be the best instrument for long-term investment. If you invest in stocks for 15 to 20 years, the effect of periodical hiccups is neutralized. According to financial experts, good stocks can offer up to 10% profit annually in long hauls but in the short term, they can be very risky.
On the other hand, money market accounts are one of the safest ways to invest, but they offer lower returns. Bonds are also good for average returns at a low risk. An effective asset allocation strategy makes use of all these instruments so that your total investment is spread out among different levels of risk and varying returns.
Pros and Cons of Asset Allocation
The biggest advantage of asset allocation is that it provides a shield against sudden market slumps. In the event that the stock market crashes one day, it will affect only the percentage of money invested in the stocks. The money invested in bonds, money market funds or other investment instruments will remain safe. Thus, over a period of time, asset allocation provides profitable results.
While planning for asset allocation, one option is to divide the money based on the risk factors associated with each instrument and the expected returns. If you want to enjoy higher returns, you need to invest a larger share of your assets in stocks. However, if you are a defensive investor, you would prefer money market accounts and invest only a small share in stocks for some quick returns.
The only disadvantage of asset allocation is that you will not be able to capitalize on sudden market surges for high return.
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