Asset Allocation: Part 3 of 5
This article is the third in a series devoted to asset allocation. The last article focused on you what items influence your asset allocation. In this article you will learn about the different asset categories.
There are three main asset categories:
- Cash and cash equivalents
- Bonds (income investments)
- Stocks (equity investments)
Each of these categories has risk associated with it. Generally, the more risk you assume, the higher the return. The relative risk pyramid below shows various investment choices ranked from highest risk and potential return at the top of the pyramid, to the lowest risk and potential return at its base.
Bonds, also known as income investments, are classified in three different ways. First, every bond is given a grade. Standard and Poors grades bonds AAA through D. Those bonds with a grade of AAA through BBB are called investment grade. Bonds with grades BB through D are called high-yield or junk bonds. Second, bonds are classified by time to maturity. A short-term bond has a maturity of less than 5 years. Bonds with maturities of between 5 and 10 years are considered mid-term. Long-term bonds are those with maturities of more than 10 years. Finally, bonds are classified into different categories. These categories include government, corporate, municipal and international bonds.Cash and cash equivalents include Certificates of Deposit (CDs), savings and checking accounts, and U.S. T-bills. These investments have low risk and thus low potential return. If too much of your portfolio is in these investments, the result likely will be that your money will not last through your entire retirement.
Some investors substitute high-dividend yield stocks for bonds in their portfolio. These are stocks that have dividend yields that are at least twice that of the large-cap average. Another way to tell if you have a high-dividend yield stocks, is to compare the stocks’ dividend yield to the current return on Treasury bonds. Treasury bonds have returned 5% over the long-run, thus any stocks with a dividend yield in excess of 5% could be considered a high-dividend yield stock.
Stocks are also known as equity investments. Like bonds, stocks are classified in four different ways. First, stocks are classified geographically. For U.S.
investors, foreign or international stocks refer to companies which are located outside the U.S. borders. See the table below for international stock investment choices. Second, stocks are grouped by their market capitalization or market cap. A market cap can be determined two different ways - (1) multiply the number of shares outstanding for a company by the present market price or (2) use the company’s sales figures. Third - growth, value and income are all types of stock categories. Growth stocks are those stocks whose performance is tied closely with earnings per share (EPS) and sales growth rates. Value stocks derive their returns from the purchase of stocks whose price earnings ratio (P/E) is lower then its historical average and/or that of its industry peers. Income stocks were described in the previous paragraph – stocks that pay significant dividends. Finally, stocks are categorized as either common or preferred stock. Preferred stocks pay set dividends regardless of the company’s performance and their share holders are placed in line ahead of common shareholders in the case of a company’s demise.
The ideal number of stocks for proper diversification is between 10 and 20 carefully chosen stocks. When you have less then 10 stocks in your portfolio you assume too much risk. More than 20 stocks in your portfolio, will not allow each stock to have enough impact on your portfolio performance to make it worth your time to track and research it. In other words, no individual stock should be more than 10% or less than 5% of your portfolio.
In addition to diversifying your portfolio by size, you should also diversify by industry to reduce risk. Ideally, your portfolio should contain between 5 and 10 industries with 1 to 2 companies from each industry. Less than 5 industries in your portfolio significantly increases your chance of a loss. On the other hand, keeping track of more than 10 industries is very laborious and statistically does not lower your risk.
In our next Series on Asset Allocation 4, you will determine your ideal asset mix. Try Bob's Retirement Calculator Today or talk to a TRUSTED Financial Advisor Today.
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Asset Allocation Series by Retire Fast LLC., (Companies and mutual funds mentioned in our blog are used as illustrations or suggestions for study and are presented for educational purposes only. They are not to be considered as endorsed or recommended for purchase by Retire Fast.) Investors should conduct their own review and analysis of any company of interest before making an investment decision. Investors should further consult their accountant, tax expert and/or financial advisor before making any investment decisions. Neither Retire Fast.. nor its content providers are responsible for any damages or losses arising from any use of this information. Copyright © 2018 Retire Fast, LLC. All rights reserved.
