Because bonds have different risks and returns than stocks, owning a mix of stocks and bonds helps diversify your investment mix. But providing income and diversification isn't the only role bonds can play in a portfolio: Most bonds, such as US Treasury bonds, can also help smooth out the ups and downs of your overall portfolio, providing some return while guaranteeing the return of principal when the bonds mature assuming the issuer doesn't default.
Though you may not risk losing any of your money, losing purchasing power to inflation can be a risk over time with conservative investments, such as high-quality investment-grade bonds. For long-term goals, short-term investments are typically only a small portion of an overall investment mix. They generally pay a minimal rate of return but can offer stability and diversification.
But how do you know how much money to put toward stocks or bonds? It all starts with you. The basic things to think about include how long you plan to invest known as your time horizon , your financial situation, and your tolerance for risk. Risk tolerance is a more personal measure than your time and money situation. History suggests that the more stocks you have in your investment mix, the more your account value may rise and fall over time. Risk tolerance asks you to consider how much stock market up-and-down you're willing to put up with in exchange for the potential for longer-term growth.
It can be a little difficult to imagine how you would feel if the value of your account fell steadily for a period of time. Some people find themselves losing sleep over temporary stock market volatility. That can lead to selling investments at a low point, and ultimately losing money—the very outcome they were trying to avoid.
That's why it's vital to choose a level of stock market risk you can live with: It can help you stay invested over time, which could give you the best chance of accomplishing your long-term investing goals. To determine your personal risk tolerance, it can be helpful to work with a financial professional and complete an investor profile questionnaire.
There are also free online tools that can help assess your risk tolerance. Your financial risk-bearing capacity is another important gauge for how much risk you can take on. It assesses your emotional and financial ability to weather declines in your account. If your goal is retirement in 20 years, your ability to take risk in a retirement account would be higher than in the account you use to pay bills.
Your retirement account has time to recover from setbacks, and any immediate losses could be recovered. In your bill-paying account, a loss could very well jeopardize your ability to pay rent next month. It's important to consider your investment horizon, risk tolerance, and risk capacity.
They don't always match up. Your ability to emotionally endure losses could exceed your financial situation. The reverse is also true: Some people are extremely loss averse no matter how much money they have. It may take an objective third party to help you accurately assess how to balance these 2 issues, so that you have the best chance to reach your financial goals. For the chance to get higher returns over the long term, investors have historically had to put up with bigger fluctuations in value over the short term.
Adding bonds and shorter-term, cash-like investments to an all-stock investment mix can have a stabilizing influence on the overall investment mix. Because the pattern of risk and returns from bonds and short-term investments is different from stock market returns, adding them to a portfolio of stocks may mitigate some of the overall volatility you experience.
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On the other hand, adding some stocks and bonds to a portfolio of stable, short-term cash investments could boost the probability of achieving higher long-term returns. Your goals and time frame, in addition to your feelings about risk, will be key factors in deciding how to distribute your investments between stocks, bonds, and short-term investments. Read Viewpoints on Fidelity. Much of investing is goal based—for example, saving for retirement, buying a home or funding a child's education. That makes it easy to understand how long you may need to be invested in order to hit your goals.
Time makes all the difference. Over a month period, the worst-case scenario would have been quite bad if you held a lot of stocks. You simply don't know which outcome you're going to get. Even if you have nerves of steel and ice water in your veins, it would still be a bad idea to invest all of your savings in stocks if you need your money in fewer than 2 years.
No one knows what the market will do: Your investments could smoothly appreciate in value, or you could end up losing half of your hard-earned savings simply because it was a bad year in the market. If you needed the cash and had to sell your stocks in this situation, your money wouldn't have a chance to recover from the negative short-term performance. Being able to stick with your plan through the ups and downs of the market is vital, because staying invested over many years is nearly always preferable to the alternative—letting time go by when you're not in the market.
After you've decided on the broad strokes for your investment mix, it's time to fill in the blanks with some investments. While there are a lot of ways to do this, the main consideration is making sure you are diversified both across and within asset classes. Diversification can reduce the overall risk in your portfolio, and could increase your expected return for that level of risk.
For instance, if you invested all your money in just one company's stock, that would be very risky because the company could hit hard times or the entire industry could go through a rocky period, taking the company's stock down with it for a period of time.
Investing in many companies, in many types of industries and sectors, reduces the risks that come with putting all your eggs in one basket. Similarly, spreading your investing dollars among different types of bond issuers and bond maturities can provide diversification on the bond side of your investment mix. A key concept in diversification is correlation. Investments that are perfectly correlated would rise or fall at exactly the same time. If all of your investments were rising and falling at the same time, you'd experience a lot of fluctuation in the value of your investments. If your investments are going up and down at different times, the investments that do well may dampen the impact of the investments that exhibit poor performance.
The end result for you is less volatility in your portfolio. Keep in mind that asset allocation and diversification influence the level of potential risk and return by degrees—diversification and asset allocation do not ensure a profit or guarantee against loss. Asset allocation is not a set-it-and-forget-it exercise. You want to revisit it periodically, or if your goals, investment horizon, or financial situation changes. Another reason it's important to revisit your investment mix is for rebalancing.
- Retributions - A Tale for the Inner Child of the Chronologically Advanced.
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- Investment Guide: Getting Started;
- Investment Guide: Getting Started | Colorado County Officials & Employees Retirement Association.
- How to start investing? With your goal.
- Photodynamics of Nanoclusters.
- How to invest | Vanguard.
Once you've set your asset allocation and investments, chances are it will begin to change as some investments do well and exceed the proportion of your portfolio that you allotted for them. Other investments may shrink. Getting your asset allocation back on track is known as rebalancing. How frequently should you rebalance? It depends on what makes you comfortable, but generally you should check in periodically, whether annually or quarterly, and consider resetting your allocation if it has strayed from your original plan.
Of course, if you are in a managed account, or target date or asset allocation fund, a professional will do the rebalancing for you.
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Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal. Thus, you could implement your asset allocation plan with ETFs when you are just starting out to avoid the minimum investment requirements of many mutual funds. When you have a k from your job , there are no minimums. In your k , you should be able to invest in any of the funds that they have with your monthly contribution, and you can slice and dice your contributions into whatever funds you want.
How do we get around it? My approach was to start with one fund. Was it the most perfect allocation plan? Did I have emerging markets, foreign funds, and a bond fund? Start with just one fund.
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And then when you have enough money to buy into a bond fund or a foreign fund, do that. And add mutual funds and diversification as your assets grow. For example, with Vanguard, you can purchase just a single share. There are some potential pitfalls with ETFs. First, in most cases, you have to pay a brokerage fee when you buy an ETF just like you do when you buy an individual stock.
The second problem is bid-ask spreads on ETFs. There is a difference between what you pay and what the seller receives. The spread varies depending on the ETF. They go into a cash account associated with your brokerage account , and you then have to reinvest the cash on your own. Having said all of that, there are some solutions. Vanguard is one of them. Vanguard does not charge brokerage fees if you buy Vanguard ETFs. Again, this makes it more affordable to invest in ETFs with Vanguard. Also, Vanguard does reinvest the dividends for you.
So Vanguard does overcome some of these hurdles that you might have buying ETFs somewhere else. But only do this if there are no brokerage fees and your dividends are automatically reinvested. They rebalance your portfolio automatically based on how much you want invested in stocks and how much in bonds. And they reinvest your dividends as well.
You can open an account at Betterment and get started with very little money. I started it as a kind of experiment, and set up an automatic deposit that goes into my account there every month. The fourth and final option is a fund of funds. Mutual fund companies will offer a single fund that you can invest in, and they will take your money and spread it out over a number of their funds to give you instant diversification.
Vanguard offers these, as does Fidelity. So you just have to deal with the minimum for that one fund. Once you do that, you have your money invested in a number of funds at Vanguard automatically. These funds automatically rebalance within the fund. As time goes by, the fund will change your asset allocation to make it a little more conservative as you get closer to retirement. Vanguard then takes your money and invests it in several of their funds for you. But there are some limitation here. For one, you have to accept the asset allocation that Vanguard has set up for these funds.
But if you just spend some time with it, and consider the above suggestions, there are some pretty simple solutions to these problems. Or you might just end up sticking with one of these options. I think either way is fine, as long as you keep your costs low and invest primarily in passively managed index funds.