Saturday, October 31, 2015

Asset Allocation: Principles of Sound Investing

Any idea of sound investing that has nothing to do with stock market?

Like when you notice the street vendors who are usually selling different items: sunglasses, hats, umbrellas. Items can be used in sunny days while some in rainy days, different items for different seasons at a time.  To diversify the product line, the vendor has to sell different items to reduce the threat of losing money at a given time. Make sense? That’s the basic of allocating assets and diversification.

Sound investing is an approach to distribute money to different investments in order to gain more or to make up from one losing investment. The basic in asset allocation is to distribute the investment portfolio to different asset categories: cash, bonds, stocks, etc.

Allocation of assets work best depends on each preferred time horizon and the willingness to tolerate risk. Time horizon is the preferred # of days, months or years to invest to different asset categories to attain the financial goal. If you prefer for a longer time horizon, you might be comfortable on a more volatile or riskier investments where you can wait a slow economic cycle; whereas, if you’re saving up for your child’s education, you might take for a less risky investment due to a shorter time limit.

Risk tolerance is the willingness to gamble for losses to get more potential returns. There are types of investors according to risk. If you are an aggressive type of investor, you are more likely to have high-risk tolerance that is willing to take risk of losing money to get the desired result; it’s like seeking two in the bush.  But, if you choose to preserve your original investment, you are likely a conservative type of investor.

Importance of risk
Reward comes after risks, as the saying goes no pain, no gain. However, you have to understand what you have to risk and what reward you’ll get. Because, to risk, there are more chances that you could lose all. There’s a reward in taking risk, but, understanding of what you risk and what you’ll get is the key to get your desired investment return. For example, if your financial goal has a long time horizon (retirement), carefully investing in assets that are riskier is the best method to make more money. Otherwise, if you have short term financial goals, cash investments might be a good option.     

Understand your choices
Securities and Exchange Commission won’t recommend any investment products. Therefore, before you leap into investing, you have to know what investment products exists, how would you like to risk, which investment product would suit your goal, risk appetite, and money you can afford to invest. 
Investments to choose from are stocks, bonds, mixed funds (stocks & bonds), money market funds/deposits, mutual funds (stocks & bonds through investment companies- Insurance and Asset Management Company), UITF (trust fund through banks), real estate investment trust fund, exchange traded fund, and government securities (T-bills, notes, municipal bonds). Investing in mix asset categories can be a good strategy. Following are the review for the 3 major asset categories:

·         Cash- cash equivalents: savings and time deposits, money market funds and deposits, government securities. These are the safest investment but gives lowest returns. There’s a slim chance of losing money for this kind of investment. Investment losses in cash equivalent do occur but not frequent. The only thing that is most concern of investors in investing cash is inflation risk. Once inflation overtakes, it will take away all investment returns and reduce the cash value over time.
·        Bonds- Usually less risky and gives moderate return compared to cash. When you reach your financial goal, you might increase your bond holding which is attractive to investors despite for lower growth potential. Similar to stocks, other bonds offered carry higher risk but higher returns.
·        Stocks- Historically, stocks are the greatest risks in investment but provide highest returns, if you know what and when to invest. Stocks offer greatest growth potential; sometimes it hits home runs, sometimes it strikes out. There volatility makes stocks a risky investment for short term. Others who invested in stocks have lost money and losses were quite dramatic. But those who have been endured the volatile stock returns over longer periods of time have been generally rewarded with greatest returns.

Above are the most common investment in asset categories. You would likely choose any of the asset categories for your retirement savings plan or education (college) savings plan. There are also asset categories like precious metals, commodities, real estate, and private equity. Other investors consider those asset category would suit their financial goals. Asset categories have specific risks; therefore, before you invest, understand the risks of what you invest and make sure the risk you take is bearable and fit for you.