Where and how you invest your money makes a difference to what your risk and return profile may look like.
You’ve got lots of choices when it comes to your money. One of the biggest ones revolves around how aggressive or conservative you want to be when it comes to managing your investments. When it comes right down to it, there are no easy answers on that front -- just different sets of risks and tradeoffs.
Generally speaking, the more aggressive you are with your investments, the higher your potential returns are, but you’ll likely face higher volatility and larger chance of catastrophic losses. The more conservative you are with your investments, the lower your potential returns are, but you’ll likely not face quite as much volatility or risk of massive losses. In addition, due to those lower potential returns, you may have a tougher time keeping up with inflation over long periods of time.
The decisions on which classes of investments to place your money in is known as asset allocation. While financial planners use broad rules of thumb as guidelines, those guidelines tend to have ranges. Those ranges are typically what determine the difference between a conservative, a moderate, or an aggressive asset allocation.
By breaking apart asset classes as cash, investment grade bonds, stocks, and more aggressive alternative investments, it starts to get possible to tease apart key differences in those allocation classes.
Cash (in a checking or savings-type account)
Typical financial planning guidance indicates that you should have between three and six months of your expenses available to you in easily accessible cash in the form of an emergency fund. This is because unexpected problems happen to all of us, such as job losses, extended illnesses, or a damaged home or car. You will need some amount of cash to deal with those problems. Having it easily available to you can help keep you from paying financing charges or being forced to sell your stocks while they’re down.
It's worth noting that while maintaining cash reserves is crucial, you can also strategically allocate some of it to earn interest. Platforms like EasyEquities offer the flexibility to keep a portion of your cash as a reserve while still earning interest, allowing you to strike a balance between liquidity and potential returns.
While cash is great to cover those immediate expenses, the downside of it is that it tends to lose purchasing power over time, particularly after considering taxes and inflation. Because of this tradeoff, people practicing more aggressive asset allocations will tend to keep their emergency fund towards the three-month end of that window. Those following moderate allocations might be closer to the six-month end of that time frame. Those who are conservative might keep even more cash on hand.
Investment grade bonds
Another common bit of financial guidance is that money you expect to spend from your investments within the next five years or so should be invested more conservatively than in stocks. This is because stock prices can fall and stay down for quite some time. If you’re forced to sell your stocks when they’re down to cover your bills, you will no longer be invested or able to participate in any market recovery that may follow.
Bonds can fill the gap between cash and stocks for that money you expect to spend in that timeframe. This is because defaulting on a bond (not paying it as agreed) can potentially trigger a company to declare bankruptcy. That might even force it to shut down and liquidate its assets to try to pay back the bond. As a result of this, if a company can pay on its bond, it very likely will pay its bond.
Investment grade bonds are ones judged by ratings agencies to have a fairly low risk of default. Those types of bonds will typically pay higher interest rates than cash investments, but they still tend to do a better job preserving your existing nest egg than building it.
As an additional note, we are excited to announce that we will be launching our bond product at the end of the year. This will provide our retail clients with a convenient way to access various government bonds, enhancing their investment options and diversification opportunities.
Within that framework, those following more aggressive asset allocations may keep a shorter period of their expenses in investment grade bonds -- perhaps in the neighborhood of three-to-five years. Those following more conservative asset allocation strategies might prefer a larger allocation -- maybe in the neighborhood of seven-to-ten years. That leaves those with a moderate asset allocation strategy again in the middle, around five-to-seven years.
Stocks
For most investors, stocks represent the bulk of the money that they have invested for growth. Indeed, for investors following a conservative asset allocation, everything not invested in cash or investment grade bonds might very well be invested in broad-based, market-tracking stock index funds. After all, stocks provide a decent opportunity for investors to not only keep up with inflation -- but also to potentially build wealth over longer periods of time.
For more moderate to aggressive investors, they will likely also have most of what remains invested in stocks, but they may choose alternatives to broad-based market-tracking index funds. Instead, they may weight their portfolios more towards individual stocks or sector-driven ETFs in an attempt to beat the overall market over time.
More aggressive alternative investments
The more conservative investors out there will likely stick entirely in stocks, bonds, and cash. Moderate ones may be willing to occasionally dip a toe into more aggressive alternatives like commodities, options, futures, or cryptocurrencies. Even then, moderate investors likely would not put more than somewhere around 5% of their portfolios towards those riskier asset classes.
The most aggressive investors out there may be willing to put a larger part of their portfolios into alternative asset classes. Still, even those aggressive investors will likely want to keep their allocation low enough so that if that portion of their account gets completely wiped out, it won’t destroy their base lifestyles. After all, while more aggressive investments could potentially bring bigger returns, they almost certainly bring with them bigger potential for losses.
Your style can change over time
All three investing styles can be valid, and they all involve different types of tradeoffs and risks. In addition, as your needs and personal risk tolerances change over time, you may find your own style changing.
Many people become more conservative with their asset allocations as they approach or enter retirement, as they recognize that their money needs to last them the rest of their lives. Others, once they build up a strong enough foundation, become more aggressive with the money they don’t think they’ll strictly need.
Whatever your current perspective is on your asset allocation, it’s important to recognize the risks and tradeoffs you face. As your life evolves over time, your asset allocation strategy can too. Just be sure that no matter which track you take, you invest with those risks in mind. That way, you give yourself a decent chance of seeing -- and keeping -- the benefits of the successes you achieve along the way.