Investing in individual stocks is a path to investment success, however it requires you to invest some of your time and energy in the process.
If you don't have the time or energy to put into investing in individual stocks, then mutual funds are the answer for you. The positives for using mutual funds include professional management to make investment decisions for you.
The negatives are that you will pay a price for their help and the result may not be any better (and could be worse) if you made all the decisions. Still, a low-cost mutual fund is a good answer for many investors.
Other investors, however are willing to put time and energy into the investing process and make their own decisions. Surprisingly, deciding which stocks to buy and sell may not be the most important decision you make.
Asset allocation is a snappy phrase that simply means dividing your investments among several different asset categories in an attempt to protect your portfolio from wild swings in any one section.
Some experts believe that asset allocation is the single most important factor in investment success.
Generally, you will want to consider a mix of stocks, bonds and cash, although some investors include other assets such as real estate. The percentage you select for each asset class and how those classes are filled is the process of asset allocation.
For example, you may decide that your particular situation calls for a mix of 80 percent stocks, 15 percent bonds and 5 percent cash. This is the first cut at asset allocation, but you can't stop there. You might further break it down this way:
Short-Term Bond Fund 5%
These are hypothetical numbers for a hypothetical investor, however due to the heavy percentage of stocks, it suggests a younger investor. You should base your particular allocation on a number of factors, including:
- Risk tolerance
- Years to retirement
- Your income
- Your savings
Splitting your assets among different asset classes helps you weather the ups and downs that are part of the investing cycle. For example, bonds and cash may add balance to your portfolio.
Investors often use the terms "diversification" and "asset allocation" interchangeably; however, asset allocation is a much more thoughtful process. Diversification means not investing solely in any one asset class. Asset allocation takes that one step further and assigns specific percentages to each category.
You will also want to make certain your stocks are not subject to the same market and economic swings. For example, it you had most of your stocks in the technology sector, a downturn in that sector would be disaster. Likewise, investing in stocks that were all interest rate sensitive (financial services, real estate, for example) might be dangerous if interest rates rose suddenly.
A general guideline is that younger investors can afford to be more aggressive because they have more time to ride out short-term drops in the market cycle. Older investors may be more comfortable with a conservative plan, particularly as they get closer to retirement. The more time you have, the better chance you have to reach your goals.
Things to Remember:
Asset allocation is the process of splitting your investments among stocks, bonds and cash.
A properly balanced portfolio can help protect you from severe market fluctuations.
Risk tolerance plays a big role in portfolio selection.
Things to Do
Look at your portfolio at least once a quarter for proper balance - more frequently in turbulent markets.
Examine your current holdings and figure out the percentage you have invested in each category: stocks, bonds, and cash, and ask yourself if you are comfortable with that mix.