The answer is to follow a risk-reduction strategy called asset allocation. Asset allocation can help reduce risk because you are dividing your dollars among a variety of investments, decreasing the likelihood that every type of investment in your portfolio would decline at the same time. Of course, it's also unlikely that every type of investment in your portfolio would go up at the same time.
Essentially, asset allocation diversifies your portfolio among several distinct classes. These include stocks, bonds, real estate, money markets, cash and more. Within these general categories, there may be several more subcategories; for instance, six classes of stocks, three classes of bonds and cash.
The stocks may be broken down into domestic stocks of small companies (small-cap), medium-sized companies (mid-cap), large companies (large-cap) and real estate. International stocks are also part of the mix, including stocks in developed non-U.S. countries and less-developed (emerging market) countries outside the United States.
The classes of bonds may include conservative, moderate and aggressive (high-yield) bonds. Conservative bonds generally include federal and state government bonds. Moderate-risk bonds include bonds issued by corporations. High-yield bonds typically are issued by corporations, offering higher interest rates to investors in exchange for a commensurate level of risk.
Stocks are securities that represent ownership in a company. You might want to invest in stocks if you believe the price of the stock will increase and thereby the value of your investment will increase. Another reason to invest in stocks would be to collect dividends. Companies pay dividends as a way to compensate shareholders for their investments. Dividends can also be a way to generate income.
Bonds represent a loan to a company or other entity. Bonds have fixed terms and fixed interest rates. They typically generate a higher income stream and are historically less volatile than stocks.
Cash and cash equivalents are considered the third basic asset class. This class includes investments such as Treasury Bills, short-term certificates of deposit and money-market instruments. Holding cash as part of your allocation can be a way to park your money while waiting for an appropriate investment opportunity. It can also be used to hold funds for emergency use.
So how do you decide which combination of investments is right for you? Start by asking yourself the following questions:
Objectives - What are your financial goals? Do you want to retire early or build your dream house? How much money will you need to save to accomplish your goals?
Risk Tolerance - Can you stomach fluctuations in the market? Do you want a steady return with little risk?
Time Horizon - Will you retire in five years? Fifteen? Are you ready to send your child to college next year or in 10 years?
Cash Flow - Do you need a steady flow of income now from your investments, or can you continue to put your money away for a few more years?
Answering these questions will help both you and your financial consultant decide what kind of asset allocation will help you meet your goals and then choose specific investments that match your allocations.
This article is provided by A.G. Edwards & Sons Inc. Member SIPC.
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