When saving for retirement you’ll want to think about more than how much you’re investing; you’ll also want to consider where your money is going. Different asset classes, including stocks, bonds, and cash equivalents, come from different levels of risks, potential rewards, and vulnerability to certain economic factors. Subsequently, investors should hold a mix of asset classes to grow, protect and access their savings in pursuit of their long-term goals.
The strategy of balancing risk and reward by holding an appropriate mix of assets is known as asset allocation. Asset allocation uses factors like your appetite for risk and your time frame to determine the percentage of stocks, bonds, and cash that you should hold.
Here’s a look at how each of the main asset classes work, and how they will work together, to generate the right mix to fit your unique financial circumstances.
Stocks. With the highest potential of return among asset classes, stocks (also known as equities) are the growth engine of your portfolio. But that growth comes at a cost. While equities have the potential to generate better returns than bonds, they’ve also experienced more volatility, historically.
Bonds. When buying a bonds or fixed-income instrument, you’re effectively loaning the issuer (a corporation or government) money. Holding a percentage of your assets in bonds can help you balance the risk in your portfolio. However, the primary risk face bonds are rising interest rates. As rates rise, the market value of any bond you already own falls.
Cash. The advantage of cash and cash equivalents (certificates of deposit and money market accounts) over stocks is their liquidity. From a volatility standpoint, cash is the safest investment in a portfolio.
Understanding asset allocation is key to developing an investment strategy that effectively and appropriately balances risk and return.
Determining an appropriate asset allocation depends on several factors, including the savings you anticipate you’ll need to fund your lifestyle in retirement and how long you have until you retire. For typical retirees, a portfolio will consist of a majority of stock when they are younger, and it will slowly taper to include more fixed-income investments as they age. Other assets in investor portfolios can also influence asset allocation. For instance, if you have a steady stream of income coming from a rental property you own, you might be able to be more aggressive with your investments for a longer period of time.
If you are unsure of your allocations, we invite you to schedule a complimentary call with one of our advisors.