The next part of the journey in our financial plan is asset allocation. When we consider the asset allocation we are talking about equities, bonds, real estate, commodities, and cash. Depending on what the asset class is will determine the return one can expect. Historically equities have outperformed bonds. But it is always very important to remember that past performance is no indication of what an asset will do in the future. But we use historic averages to help gauge what an asset may do in the future. I am sure you have heard the old adage that “no risk, no reward”. That saying will play a major role in one’s asset allocation depending on their risk tolerance. Obviously some assets classes are more risky than others and therefor they should expect higher returns for the added risk taken. Asset allocation as a rule will change as one gets older and it generally becomes more conservative in nature.
When you are younger you can afford to take more risk in your investing than someone who is approaching retirement. The reason behind that is due to the fact younger people have more time to make up for and correct any losses that they may encounter. As someone approaches retirement they cannot afford to sustain losses of their principal in such a way as someone younger. That is because they will have a shorter time period to recover from any such losses. When you are younger or if you feel as if you can afford to take more risks it would be wise to invest more in equities rather than bonds or commodities. Real estate is an asset class that takes a special type of investor to own the actual property but the use of real estate investment trusts is something that is more acceptable to the investing public in general. Commodities such as gold and silver are viewed as hedges to inflation and can be owned either by having the actual metal in bullion form or through mutual funds or exchange traded funds. But again someone who is younger should focus their attention mainly on equities.
Now as far as equities go in America there are basically three types of classes for equities. The riskiest US equity class is small cap stocks which also have the highest returns of the three US equity classes. The next is mid cap stocks which are comprised of companies that are medium in size and they return the next best return. And finally the large cap stocks which most people know as the S&P 500 types stocks have the lowest return of the three equity classes but it still is better than any other asset classes return. You can also invest in foreign markets to provide a broader base for diversification but it is advisable to do this by investing in mutual funds or exchange traded funds to reduce the risks associated with owning a single stock. While equities may have the highest risk they also provide the highest returns. But by investing across the entire spectrum of equities with the use of mutual funds and exchange traded funds can actually reduce the portfolio’s overall risk while maximizing your returns.
The next asset class to have reliable returns over the long haul are bonds. There are three classes of bonds that are sold and traded in the US and they are government bonds which are federal government and municipal bonds, corporate bonds, and high-yield bonds or junk bonds. The lowest risk is in federal issued bonds as the federal government has never defaulted on any of its debts. As they are the lowest in risk they also have the lowest returns of the three US based bonds. Municipal bonds are next as far as risk as few issuers of these bonds have defaulted although in recent years it has become a little more common. These bonds will pay a little higher of a rate compared to federal issued bonds. Government bonds also pay lower yields due to the fact that they are tax advantaged as compared to the other types of bonds issued and the owner does not have to pay either federal or state income taxes depending on who issued the bond and where the owner lives. Corporate bonds will pay higher yields than government bonds and they do carry more risk of default. Corporate bonds as with any bond are rated by a bond rating agency and you will have investment and non-investment grades. Most government bonds have investment grades unless you are dealing with a municipality that is in financial trouble. Investment grade corporate bonds have historically been decent investments and as the bond goes down the grading scale the interest rate that they must pay will have to increase due to the additional risk associated with owning the bonds. Junk bonds are the riskiest and therefor pay the highest interest rates of the US based bonds. Just as with equities, bonds are sold by foreign companies and governments and if you desire to diversify into foreign bond markets it is best to do so through mutual funds or exchange traded funds. Just as in US based bonds foreign bonds are rated by the bond agency rating companies.
As we reduced risk we have also reduced the expected return. Again, someone who is younger should focus their attention on domestic and foreign equities with possibly a little devoted to other asset classes. As a person goes through their life and approach retirement they tend to shift their focus from equities to safer income producing assets such as bonds or blue chip stocks that pay dividends. The key for any investor is to assess their risk tolerance and invest accordingly. And then you must re-evaluate your risk tolerance on a regular basis and adjust your portfolio accordingly as well. This goes with assessing your assets allocation to ensure that your portfolio stays consistent with your risk tolerance and goals. That means if one asset class goes up or down by say 5% you sell assets that appreciated and buy assets that did not do as well. If you do not wish to sell assets if they are in a taxable account and you invest on a regular basis you can invest more in the asset that did not perform as well and less in the ones that did better. By investing this way you rebalance your assets and you do not trigger any tax consequences.
Some financial advisors will say you need minimal equities as you enter your retirement years. I feel that equities still will play a major role in anyone’s retirement portfolio mainly because someone may be in retirement for 30 plus years. If someone were to be in retirement for that long of a period of time relying solely on income producing assets will make it difficult to ensure you do not run out of money before you die. That is why it is important to maintain some percentage of equities even in retirement. That is because equities tend to appreciate in value at a pace that one will outpace inflation and two provide your portfolio the chance to add to its principal base thereby increasing the overall value of your portfolio. Even in retirement it is not unreasonable for someone to hold about 30% of their portfolio in at least established large cap companies.
