Balance Risk & Reward with Proper Asset Allocation

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual’s retirement goals, risk tolerance and investment time horizon. There are three main asset classes - Equities, fixed-income, and cash and equivalents – each has a different level of risk and reward, so each will act differently over time. There is no one-size-fits-all answer to the question of proper asset allocation, and an individual’s ideal mix depends on their age, risk tolerance, and time frame until retirement.

Time Horizon

How does an individual’s time horizon play into asset allocation? Time horizon is the expected number of months, years, or decades an individual will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable roller coaster of ups and downs of our markets. Compare that to someone with a shorter time horizon until retirement that might feel more comfortable taking a more conservative approach to preserve the funds they have allowed to build up over a longer period of time. The risk tolerance concepts of “Aggressive vs. conservative” investing may intertwine with a person’s time horizon or age.

Risk Tolerance

How does an individual’s risk tolerance play into asset allocation? Risk tolerance is an individual’s ability and willingness to lose some or all of their original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In general, a younger person with a longer time horizon until retirement might be a more aggressive investor compared to someone a bit older with a shorter time period until retirement, in which case, that investor might lean more toward a more conservative asset allocation. Again, there is no one-size-fits-all solution to selecting investments but an individual’s time horizon and risk tolerance will most likely play a significant role in how one would choose their asset allocation within their retirement plan. Two more considerations are listed below, that might factor into how an investor looks at asset allocation.

The Wonderful World of Diversification

The practice of spreading money among different investments to reduce risk is known as diversification. While diversification doesn’t guarantee profits or provide assurances that investments won’t decline in value, it does lower risk. By spreading investments across a variety of asset classes, investors lower the probability of volatility in their portfolios. Overall returns won’t reach the highest highs of any single investment – but they won’t hit the lowest lows either. For investors who want to avoid some of the stress of down markets, diversification can help lower volatility.

The Beauty of Target Date Funds

A Target Retirement Date Fund is a mutual fund in the hybrid category that automatically resets the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor. Target Retirement Date Funds are an option that does everything for an investor. Each one has a date, a date that most closely corresponds to the year or closest year in which an individual plans on retiring. An investor would not need to pick and choose from a menu of investment options, allocating funds to a mix of money market or stable value funds, bond funds and stock funds. Instead of having to choose a number of investments to create a portfolio that will help them reach their retirement goals, Investors are able to simply choose a single fund designed to help them reach that goal. Asset allocation is automatically done within each fund. Each fund is designed to help manage risk while trying to grow your retirement savings. Its returns are not guaranteed however, but depend on how the market performs. Participants do need to take into account their own risk tolerance when choosing which fund is right for them. Refer to your employer’s retirement plan to see if Target Retirement Date Funds are an option for you.

Although there is not a “one-size-fits-all” option when it comes to choosing investments, proper asset allocation in your retirement plan’s investment portfolio can help you manage your risks and meet your retirement goals.