No doubt you’ve heard there’s no reward without risk. That’s as true of investing as it is of anything else in life.
Historically, each of the three major investment asset classes—stocks, bonds, and cash—has produced pretty consistent long-term returns, along with pretty consistent degrees of risk. Understanding these historical patterns can help you handle risk in your own portfolio.
Fundamentally, how you allocate your assets among stocks, bonds, and cash depends on how much risk you’re willing to take for an expected return. And that depends on why you’re investing, and when you need your money.
So, what’s the right way to divvy up your portfolio? You’ll need to answer three basic questions:
1. What is your time horizon?
To manage risk effectively, first establish your goals. (Are you saving for retirement or a vacation? Or both?) Next, set a reasonable time period to reach them. Generally, the longer your time frame, the more money you can consider allocating to stocks and stock funds, which have had the greatest long-term potential for growth.
2. How well do you sleep at night?
This is what our investment manager refers to as the Sleep at Night Index. Although, over the last 80 years stocks have turned in the strongest overall long-term performance of all three asset classes, their annual returns have fluctuated much more dramatically than for bonds and cash. So, having a mix of stocks and bonds in your portfolio sometimes can lessen the severity of turbulence nightmares.
3. Are all your eggs in one basket?
The famous words; Diversity, Diversity, Diversity. Investors can further reduce their investment risk through diversification. That means spreading assets around—across different asset classes, market sectors, capitalization levels, and countries.
Once an asset mix is implemented, day-to-day movements on Wall Street can change the portfolio balance without you noticing it, even if you never make another transaction.
In a long bull market, the relative value of your stock funds might grow to dwarf your holdings in bonds and cash. As a result, you’d be taking significantly more risk than you’d originally intended. That’s why it’s wise to periodically rebalance your portfolio to keep it from drifting too far from your asset allocation targets.