The importance of an investment strategy based on an organized plan rather than on tips or impulse cannot be overemphasized. Most advisers recommend using a mix of asset allocation diversification and rebalancing.
Asset allocation involves choosing which categories of investment get which portion of your savings. Diversification is part of this approach. Asset categories are defined as groups of securities or investments that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. Within each asset category, you should purchase a variety of instruments – equities (stocks), fixed income (bonds), and cash or cash equivalents – to reduce the volatility of a single entity or market sector.
Within equities, options include large caps (market capitalization above $10 billion), mid caps ($2 billion to $10 billion), and small caps ($300 million to $2 billion). There are also non-U.S. stocks, from both developed and emerging markets. Many equities are subclassified into value stocks (those that appear to be underpriced but may increase when the market "notices" their potential and corrects the price) or growth stocks (those with potential for continued growth). Fixed income investments include government bonds (U.S. Treasury and municipal), high-quality corporate bonds, and high-yield (junk) bonds.
Cash equivalents, such as cash, certificates of deposit, and money market instruments, are safe but currently are yielding historically low rates of return.
Choice of assets and allocation should be dictated by your age, number of years between now and when invested funds will be needed, goals, and risk tolerance. Younger investors can generally allocate a larger percentage of funds to equities, while those closer to retirement age may want to shift away from stocks toward fixed income investments. An old rule of thumb has been to subtract your age from 100 and put that percentage into equities. Nowadays, it might be wise to subtract your age from 110 or even 120.
Bonds have a lower traditional yield curve, but are less likely to depreciate in value when the market fluctuates. Bond prices traditionally move in the opposite direction from interest rates. The highest bond yields are obtained from longer-term instruments. When interest rates increase, bond prices (i.e., what they sell for day to day, not their value at maturity) fall. This fact is important if you have to liquidate bonds before maturity.
The allocation of assets is the most important decision an investor makes. A sample asset allocation is as follows:
• U.S. equities, 30%.
• Non-U.S. equities, 30%.
• High-quality corporate bonds, 10%.
• High-yield bonds, 10%.
• U.S. Treasury bonds or TIPS, 10%.
• Real estate, 5%.
• Gold and precious metals, 5%.
The Securities and Exchange Commission website provides good investment advice. Online calculators you may find useful for your asset allocation are as follows:
To diversify, you must purchase a variety of stocks, bonds, or mutual funds. The advantages and disadvantages of each will be the subject of a later column.
Disclaimer: The views and opinions expressed in this article are those of the author. Dr. Bailey is not a financial adviser; the information is this column is general, not authoritative, and cannot substitute for the advice of a professional financial planner.
Dr. H. Randolph Bailey is an ACS Fellow on the Board of Regents and a colon and rectal surgeon at the Methodist Hospital in Houston.