Asset Allocation: The Investment Pyramid

asset-allocation-the-investment-pyramid

Asset Allocation, the single most important factor in determining investment returns. Diversification among the various asset classes is a must; cash, bonds and stocks. And diversification within each asset class is strongly suggested. Diversification increases returns while lowering risk.

Risk/Reward Ratio

Risk tolerance will determine how much to put into each asset, since each asset has a different risk level. Cash is the safest and returns the least. Bonds offer income and preservation of capital, but have a bit more risk. Stocks over time offer the best return, but also more risk. The speculative investments such as real estate and commodities are the riskiest of investments. Asset allocation by age.

Cash

Cash is defined by the Financial Accounting Standards Board (or FASB) as currency on hand, both paper and coin, checking and savings account balances, checks, money orders and short-term instruments such as commercial paper, certificates of deposits, t-bills and money market accounts that can be converted quickly into cash with no change in value.

Bonds

Bonds are IOUs, issued by the federal governments, state and local municipalities and corporations in exchange for money. The issuer promises to pay a stated amount on interest, usually semi-annually, for the duration of the loan and repay the entire principal amount upon maturity. Bonds generally have a maturity of more than ten years. If due to mature in less than ten years but more than one year, the loan is called a note. There is an active secondary market that offers liquidity, but no guarantee of full principal repayment if redeemed before stated maturity.

Stocks

A share of stock is a piece of ownership in a corporation. Most shares of stocks are publicly traded but can be issued by private placement. As the fortunes of the issuing corporation rise, so does the value of the share issued. If the company fails, the stock can become worthless. Stock owners are called shareholders or stock holders and have a say in decision-making called voting rights. Profits distributed to shareholders are called dividends.

Real Estate and Commodities

Speculative investments such as real estate and commodities are considered speculative because they are relatively illiquid, not easily converted into cash, and involve a great deal of risks as there is no guarantee of success. Recent financial turmoil has its roots in such speculative investments as auction-rate securities, credit default swaps, and sub-prime mortgages. A comfortable mix of the above assets can reduce risk while increasing returns, and should be reviewed periodically to maintain investment goals and strategies.

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