Risk Management: Asset Allocation

A variety of factors may cause one to act more cautiously than normal, including ongoing global uncertainties and fears about the overall economy. This can lead to investors flocking to low-risk investments despite misalignment with their goals. Whether your retirement is years away or right around the corner, your investment portfolio should be designed with your financial goals in mind. Remember, while minimizing risk can feel like a safe move, you could miss out on long term opportunities as a result.

Markets can be turbulent and expecting potential declines is normal. There can be a strong temptation to pull out of markets when they become volatile. However, instead of acting on this temptation, it may be smarter to do nothing if your investment approach is appropriate.

Determining an Appropriate Mix

When you created your investment strategy, your asset allocation reflects your time horizon, your goals and tolerance for risk.

Time

Investors with longer timeframes may be comfortable with investments that offer higher potential returns but also carry greater volatility. A longer timeframe may allow individuals to ride out the market’s ups and downs. An investor with a shorter timeframe may need to consider market volatility when evaluating various investment choices.

Goals

They come in all shapes and sizes, and some are long-term, while others have a shorter time horizon. Knowing your investing goals can help you keep on target.

Risk Tolerance

An investor with higher risk tolerance may be more willing to accept greater market volatility in the pursuit of potential returns. An investor with a lower risk tolerance may be willing to forgo some potential return in favor of investments that attempt to limit price swings. The three most common risks to your investments:

Interest rate risk is the potential for investment losses resulting from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-income investment will decline.
Market risk is the risk that arises from movements in stock prices, interest rates, exchange rates, and commodity prices.
Inflation risk is the chance that the value of assets or income declines or erodes as inflation shrinks the value of purchasing power.

Asset Allocation

One of the most important concepts for any investor to understand is asset allocation.¹ The saying “don’t put all your eggs in one basket” has some application to investing. Put simply, asset allocation describes the division of stocks, bonds, and cash that make up your investment portfolio. Although this concept is straightforward, it has one of the largest impacts on your financial future.²

Over time, certain asset classes may perform better than others. If your assets are mostly held in one kind of investment, you could find yourself under a bit of pressure if that asset class experiences volatility.

Stocks, also called equities, allow you to own a share of a publicly traded company. By investing in stocks, you have the potential for a higher return on your investment. But if the company has a bad year, or if the economy takes an unexpected turn, you may also lose money.³
Bonds, overall, have been a steadier source of fixed income. However, bonds are subject to interest rates and inflation risks, and their rate of return tends to be lower.⁴
Cash and cash equivalents give you flexibility for any unexpected emergencies that may arise. If your hot water heater dies, having funds on hand to take care of it without resorting to a credit card is helpful. However, your cash-on-hand will not earn you money the way other investments might.

Like diversification⁵, asset allocation is an approach to help manage investment risk. It does not eliminate the risk of loss if an investment sees a decline in price.

Over time, your investment strategy may need adjustments to reflect your new investing priorities especially if any of the inputs have changed. “Setting it and forgetting it” may sound appealing, but changes in the market warrant a portfolio review to make sure your asset allocation still makes sense. Asset allocation and diversification are critical building blocks of an investment portfolio. An investment professional may be able to help review your allocation especially when markets are volatile. They can answer questions, provide reassurance, and show you the opportunities that volatile markets may provide to adjust your investment strategy.