Asset allocation is an investment strategy of diversifying your investments among different kinds of asset classes, such as stocks, bonds, real estate and cash. While asset allocation does not assure a profit or protect you against a loss, a diversified portfolio can help you weather the market’s ups and downs and potentially reduce the level of volatility in your investment portfolio. Here are the dos and don’ts of asset allocation.
Rebalance annually. There’s usually no reason to reallocate more frequently than once a year, but you may review you asset allocation during your mid-year financial check-up as well. Though your risk tolerance may not change that often, volatile market conditions or a major life event like a sudden job loss may prompt you to re-balance. Pick a date each year to review your portfolio and be as consistent as possible. Note that rebalancing may result in product and/or trading fees and realized gains or losses.
Stick to your long-term asset allocation strategy. That means rebalancing your portfolio to match your fixed goals or percentages instead of trying to predict where the market is headed. It can be easy to react emotionally to market swings, but maintaining consistency in your strategy is generally the best way to ride out economic headwinds.
Consider the tax implications. To help avoid big tax bills, ask your tax or financial professional whether putting your investments in tax-sheltered accounts might be right for you.
Take on more risk than you can tolerate. Don’t confuse personal bravado and risk-taking with the risk that’s appropriate for your portfolio. Your investing risk tolerance should reflect your financial situation and how you would manage if the market dipped. If you wouldn’t be able to handle a nosedive, adjust your asset allocation to lessen your risk. On the other hand, you may be more conservative than you should be based on your time horizon and unique financial goals. Aim to look objectively at your portfolio and re-asses your risk tolerance regularly.
Hold too many investments as a diversification strategy. For example, if you invest in more than one mutual fund with the same objective (ie. aggressive growth), those funds can carry the same risk. A sound asset allocation strategy requires true differentiation across various classes of investments.
Expect asset allocation to do it all for you. Unfortunately there is no magic bullet for investing success. Asset allocation is simply a strategy that may help improve your investing results. When applied carefully in the context of a long-term outlook and overall financial plan, it can be a very helpful tool, but it isn’t a sure way to protect your nest egg completely from the frequent ups and downs of the markets.
Rebalancing your portfolio can be complex. If you don’t already, consider working with a financial advisor who can help you determine your risk tolerance and an appropriate asset allocation strategy for you based on your financial goals and situation.