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It's no secret that throughout history common stock has outperformed most financial instruments. If an investor plans to have an investment for a long period of time, his or her portfolio should be comprised mostly of stocks. Investors who don't have this kind of time should diversify their portfolios by including investments other than stocks.
For this reason, the concept of asset allocation was developed. Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds, stocks, real estate, and cash. Each asset class has different levels of return and risk, so each will behave differently over time. At the same time that one asset is increasing in value, another may be decreasing or not increasing as much.
The underlying principle of asset allocation is that the older a person gets, the less risk he or she should take on. After you retire, you may have to depend on your savings as your only source of income. It follows that you should invest more conservatively because asset preservation is crucial at this time in life.
Determining the proper mix of investments in your portfolio is extremely important. Deciding what percentage of your portfolio you should put into stocks, mutual funds, and low risk instruments like bonds and treasuries isn't simple, particularly for those reaching retirement age. Imagine saving for 30 or more years only to see the stock market decline in the years before your retirement! For many, this is what happened during the bear market of 2000 and 2001. To determine your asset allocation plan, we strongly suggest that you speak to an investment advisor who can customize a plan that is right for you.
Next: Financial Concepts: Random Walk Theory »
Table of Contents
- Financial Concepts: Introduction
- Financial Concepts: The Risk/Return Tradeoff
- Financial Concepts: Diversification
- Financial Concepts: Dollar Cost Averaging
- Financial Concepts: Asset Allocation
- Financial Concepts: Random Walk Theory
- Financial Concepts: Efficient Market Hypothesis
- Financial Concepts: The Optimal Portfolio
- Financial Concepts: Capital Asset Pricing Model (CAPM)
- Financial Concepts: Conclusion
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