Investing for retirement: The risk/reward calculation
by David SmithInvesting for retirement has been the buzz phrase for several years now. In fact, many of the largest investment firms have spent a lot on marketing to attract those retirement assets. There are also many statistics about what it takes to retire, and many calculations you can do that will estimate what you need to retire.
But the best advice you can take is to start early, invest consistently and make sure you have a diversified portfolio to help you ride out the ups and downs of the market.
Asset allocation is the term given to a strategy that diversifies investment dollars among different types of assets classes like stocks, bonds and cash. It is one of the cornerstones of building a long-term investment strategy.
At its more sophisticated level, asset allocation requires a more refined approach to asset class diversification to include such asset types as small cap stocks, international stocks, government bonds, corporate bonds, etc. As you can see by the above chart, each asset class performs differently depending on the market. That is why, if you are investing for retirement, you should consider allocating your assets among several of these asset classes.
For example, someone who is saving for retirement more than 10 years away, who is willing to assume a moderate level of risk, would probably have an asset allocation of approximately 50 percent to 70 percent stocks, 25 percent to 45 percent bonds and 5 percent in cash or cash equivalents.
This moderate portfolio gives the investor some exposure to the higher potential returns of equities while moderating the risk by investing a significant amount of the portfolio in high-quality bonds. Again, depending on the investor, you may have heavier weightings in either one of these asset classes, all based on the investors risk profile, time horizon, etc.
By diversifying your assets among different asset classes, you can mitigate potential risks in your portfolio. This is intuitive. We know that when equities are performing well, bonds may not be performing at the same levels. Thus, by investing in both, you can take advantage of investing in those higher-performing asset classes while also safeguarding your principal by taking some of the risk out with securities that tend to have less risk.
Determining your degree of risk
Each investor has a different tolerance for risk, and many variables can determine the appropriate asset allocation for their investment portfolio. An investment adviser must know the psychological limits for each investor. How much risk can a client stand? This is a highly individual, highly subjective matter, but is critical in determining the proper allocations.
Additionally, factors such as time frame, tax position and liquidity needs also contribute to the formulation of a properly allocated investment portfolio.
So how does an investor determine what is the appropriate asset allocation strategy? Basically, there are two approaches to forming an asset allocation strategy:
Tactical allocation: This method involves trying to time the markets and picking stocks based on market conditions. It is risky, even dangerous, to try to determine when to get in and out of the stock or bond market. It is also very difficult to predict interest rate movements, or to properly assess growth or value stocks without the aid of substantial research.
Strategic allocation: This method is built around you, the investor. It takes into account your time horizon, your personal risk profile, liquidity needs and the tax consequences of your investment. This approach is widely used by financial advisers.
Under any circumstance, you must maintain a disciplined approach. That is, set your strategy and stick to it, and be sure to review your circumstances on a regular basis to determine if your asset allocations should be modified. You may also consider engaging an investment manager or financial adviser to help you develop your particular investment strategy.
David Smith is the Chief Investment Officer for Rockland Trust and is a Certified Financial Analyst. He can be reached at David.Smith@RocklandTrust.com.
Published in Cape Business Health & Wealth July/August 2007
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