Even if you’re new to the world of finance and the stock market, you might already know some of the fundamental principles of investing. There are examples everywhere and we experience them constantly in our day-to-day lives. Have you ever noticed that sidewalk vendors sell seemingly unrelated products—like maybe umbrellas and sunglasses? At first glance, that might seem really strange—who is buying both of those products on the same day? No one! And that’s the point. They know that when it’s raining the umbrellas will be a hot seller and when it isn’t, the sunglasses will be. By offering both items to passersby, they are diversifying their inventory and mitigating the risk of losing sales based on something they can’t control, like the weather.
Diversification and asset allocation are closely tied together and both equally important as part of your investment strategy. Asset allocation is the practice of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash.
Asset allocation is important because it balances your portfolio and steels it against a storm of uncertainty. When you allocate your assets across different classes you have returns that move up and down under different market conditions within a portfolio, allowing you to protect yourself against major losses. Historically, the returns of the three major asset categories have not moved up and down at the same time.
Economic and market conditions that cause an asset category to do well often cause another asset category to have average or even poor returns. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category. If all of your investments were stuck in one asset class category, you could lose a significant part of your portfolio with just one market shift.
Asset allocation could also mean the difference between you meeting your financial goals and not quite reaching that finish line. And it’s not just about playing it safe: If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goals. For example, if you are saving for a long-term goal, like retirement or college tuition for a loved one, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. But! If you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, wouldn’t work for a short-term goal, such as saving for a family’s summer vacation.
Cash. This doesn’t mean money under the mattress (although it is a good idea to keep a little bit of cash on hand for the ice cream truck and life’s little surprise expenses). Financially speaking, cash includes checking accounts, savings accounts, money market accounts, and certificates of deposit—think anything that is highly liquid, meaning you’re able to pull the cash out in one day or less.
The only exception in liquidity is CDs, which usually have an early-withdrawal penalty fee.
Not only are these assets accessible, but they’re all FDIC-insured, meaning the Federal Deposit Insurance Corporation will guarantee the safety of your money up to $250,000 per depositor and account at a covered bank.
Bonds. Bonds are loans made by an investor to a borrower, typically corporate or governmental entities that are using them to raise capital. While bonds are considered to be lower-risk investments than stocks it doesn’t mean they are risk-free. The entity that issued the bond could fail to make an interest payment or pay the principal back, it’s not common but it does happen. You can gauge how likely it is that a bond issuer will default on its payments by looking at its bond rating, which functions much like a consumer credit rating. The higher the bond rating, the greater the financial health of the issuer and the higher the likelihood that they’ll be good to pay back the bond and interest.
Municipal bonds are issued by local government entities to raise money. Let’s say a city needs to upgrade a park for $10 million, and they don’t have the budget for it. To raise the money needed, it could issue bonds to cover the cost. The bonds would mature after a set period of time and would pay a set interest rate to the investors. The city gets its upgraded park and the investors make a little bit of interest as well in exchange for lending them the money.
Corporate bonds are issued by companies to raise money for capital expenditures, such as a new factory or an increase in research and development.
U.S. Treasury bonds, sometimes called “T-bonds,” are issued by the federal government and have maturities of over 10 years. They are considered virtually risk-free, as it would take a catastrophic event for the U.S. government to fail to meet its debt obligations. That safety comes at a cost. Because of the low perceived risk in investing in U.S. Treasury bonds, the yields are almost always lower than investors can receive from corporate bonds. Income from Treasury bonds is exempt from taxes at the federal level, but not at the state or local level.
Stocks. A stock represents a stake of ownership in a business. The words “stocks” and “shares” are almost interchangeable. “Stocks” is the more universal, generic term. It’s used to describe a slice of ownership of one or more companies. In contrast, “shares” has a more specific meaning: the ownership of a singular company. To invest is essentially to own a piece of a company, in the form of shares of company stock. They may be purchased individually or as part of a mutual fund or ETF.
A mutual fund is a pool of money from many investors brought together in order to invest in a large group of assets—like stocks and bonds and sometimes even other mutual funds. The portfolio holdings are managed by professionals. The many individual investors buy shares that rise or fall in value based on the performance of the fund’s holdings.
These investors don’t own the stock in the companies the fund purchases, but share equally in the profits or losses of the fund’s total holdings—that’s what puts the “mutual” in “mutual funds.”
An exchange-traded fund, or ETF, is a collection of securities that you can buy or sell through a brokerage firm on a stock exchange. They’re very similar to mutual funds, but with one twist: An ETF is bought and sold like a company stock during the day when the stock exchanges are open.
You can invest in ETFs through Public, either by purchasing full shares or by purchasing slices of ETFs. Check out the Funds for Everyone Theme for a sampling of ETFs available in Public.
Alternatives. Alternative assets are less traditional and more unexpected investment options. Cryptocurrency, real estate, art, foreign currency, insurance products, derivatives, venture capital, private equity, and distressed securities are all good examples.
Investment objectives and asset allocation
Asset allocation becomes especially important as we age. The old rule used to be that you should subtract your age from 100 to find the percentage of stocks you’re meant to maintain in your portfolio. So, if you’re 30, you would keep 70% of your portfolio in stocks; likewise, if you’re 70, you should keep 30% of your portfolio invested in stocks.
The fact of the matter is that Americans are living longer and longer these days, so many financial planners are now recommending that the rule should be closer to 110 or even 120 minus your age. The logic here is that if you need to make your money last longer, you’ll need the extra growth that stocks can provide.
Time isn’t the only consideration when deciding on your own personal asset allocation. Risk comes into play as well. Some of us like risk and some do not, we all have our own tolerance. To invest you need to understand the inherent market risk—but your time spent in the market makes the biggest difference. By taking the time to understand your risk tolerance, you can ensure that your investments are within the level of risk you’re comfortable with. There’s a balance: Taking on too little risk is as bad as too much risk. To invest is to take on risk so that you have the opportunity for the return that could come along with it. There have been market events that have seen people gain based on the risk they are willing to take.
Asset allocation and diversification
Alas, just because you’ve mastered the art of asset allocation does not mean you are appropriately diversified. For example, if you have decided that you should have 80% of your investments in stocks, it doesn’t mean you should invest 80% of your money in one stock.
To be well-diversified you should have representation in each investment category. Even better, some experts recommend owning as much as 50 stocks in each category. Buying into an ETF or mutual fund is one way to accomplish that. Public offers ETFs in each of its Themes and they buy and sell just like shares of stock.
How to activate your allocation strategy
You’ve figured out your ideal asset allocation, you have your sights set on diversification, and you’re ready to go. Now what?
There are a few options. The first one is a target-date fund, a kind of mutual fund that holds stocks and bonds. They’re typically named with the target date in the title to make it super simple to choose. So, if you plan to retire in 2050, you might choose one named XYZ2050.
The second is to completely take it on yourself with a clever DIY approach. You’ll need to research ETFs and mutual funds that match your target allocation types. Then you’ll need to research what stocks you’re thinking of getting into. After your buy-in, you’ll need to keep track of your portfolio
The other option is to completely let the algorithms take over and surrender your control to a roboadvisor. They are the most hands-off approach because they provide investment management online based on mathematical rules.
No matter which method you choose, you’ll need to rebalance every once in a while. As your life changes so will your risk tolerance, and that should be addressed. It’s a good idea to check in every few months to make sure that what you’ve chosen is still working for you.
The bottom line
Like everything else in finance: There is no one size fits all approach. Your personal asset allocation strategy will change based on your desired rate of return, your risk tolerance, how much time you have to manage your portfolio, and how much understanding you have of different assets. Using tools like Public’s social aspects and l