Asset Allocation: Casserole for Investing
Asset Allocation (the mix of asset classes) for your investment portfolio is actually a lot like a cooking up a casserole for dinner. The process of determining what mix of investments you should hold is not much different than adding a cup of this and half a cup of that.
Think about the stock exchange like going to the grocery store. Your investment portfolio is your grocery cart. You’re going to want to buy ingredients that will end up making a really great dinner: chips and salsa (Hormel Food), Mexican casserole with chicken (Tyson), avocado (Calavo Growers), corn (Pinnacle Foods), spices (McCormick & Co), and dessert (Kellogg). The quantities listed in your recipe provide you with guidelines for how much to buy.
Just as there are lots of different ingredients, there are many subcategories of asset classes, but there are a few main ones.
Main Subcategories of Asset Classes in Asset Allocation
- Equities – stock ownership in a company represented by the number of shares you have
- Fixed Income – loaning money to the government or a company that pays you interest until they pay back the amount you loaned them
- Real Estate – property
- Commodities – things like gold, oil, water
- Cash and cash equivalents – money in the bank or under your bed
The ingredients for your asset allocation that work best at any given point in your life will depend largely on your time horizon and your ability to tolerate risk. I have had people bring me their portfolio thinking they were diversified only to find they had chosen different investments that all do the same thing. It was like they chose chips, chips, and chips, albeit of different brands.
Your time horizon is the amount of time that you will be investing to achieve a particular financial goal. Think of this as the length of time you have things cooking in the oven. If you have a longer time horizon, you may feel more comfortable taking on riskier or more volatile investments because you can wait out slow economic cycles and the inevitable ups and downs of our markets. But if you have a shorter goal, like saving for a car, you need to be more careful, as if you were cooking something delicate and particularly time-sensitive, like a soufflé.
Risk tolerance is your ability and willingness to lose some or all of your original investment for greater potential returns. Think of this as how much spice you can stand. A waitress is going to ask you just how hot is hot for you. Before investing, a reputable company is going to ask you to answer questions about your goals, time horizon, and risk profile in order to design appropriate investment asset allocation. They usually begin by asking about your goals, understanding of investments, willingness to accept risk, and capacity to withstand periods of market volatility. Ultimately, you choose how safe or risky you want your portfolio of investments to be.
There is no single asset allocation model that is right for every financial goal. You need to use the one that is right for you. The main goal of allocating your assets is to minimize risk given a certain expected level of return. Appropriate asset allocation is like a casserole combining several ingredients into a single dish. It’s a comfort food which makes you feel better.