Profiting with Asset Allocation and Rules of Thumb

When you start investing, you see there are a lot of investment choices up for the picking. However, you need to decide wisely on which to select and how much of your capital to invest in them. Here’s where asset allocation comes into play. Read on to learn more about it, plus important rules of thumb you can use as guides.

Decision Making in Investment

The term asset allocation is a one that’s used by investment professionals to describe how to distribute investment dollars to achieve an expected rate of returns based on certain factors.

Individual investors should consider these factors, including current income and expected future income, investment time horizon, and tax implications.

For any 20-year period, investment returns from various asset classes have been mixed. You can imagine a couple or more years of good returns followed by a year of low returns.

What this means is that if you put all your money in one asset year after year, you will receive lower and more volatile returns than when you spread your investment dollars among different asset classes.

You obviously have to make some decisions on which asset classes to spread or to allocate investment dollars due to certain combinations of investments, which are based the degree of aggressiveness (or risk tolerance) needed to meet targets.

Overview of Asset Classes

Asset classes include equities and fixed income. Investing in equities lets you become a part owner of a company. Basically, you have an equity interest in the company but during the case of bankruptcy, you have very little to no claim. This makes it a relatively risky investment.

On the other hand, fixed income means that you receive a predetermined stream of income from the investment, typically in the form of a coupon. In the event of a bankruptcy, you will have a senior claim to liquidate assets when compared to shareholders. Bonds are the most common form of fixed income traded in public companies.

These asset classes can also be broken down into sub-classes. For equities, these sub-classes include domestic, and global. For fixed income, investment grade corporate bonds, high yield or junk bonds, and government bonds.

Rules of Thumb

There are some general rules of thumb that can help you through the shorter term and more common fluctuations of the market.

  • The stock market is leading; meaning its movements often precedes the changes in the economy that affects labor, consumer confidence, and earnings reports.
  • The policy and the impact of decision making from the government because of various economic data are mid- to lagging indicators in terms of the conditions of the market.
  • If you watch money flows, which are the movement of money in and out of a stock, sector, or asset class, when the chart shows a peak or bottom in money flow, you should do the opposite. A contrarian view may be your best choice in this kind of situation.
  • Options, which are a kind of derivative instrument, can prove to be very profitable in a volatile market. You can use the VIX (Chicago Board Options Exchange Volatility Index) as a good indicator of market volatility. When the VIX is expected to move higher, investing in options instead of owning the equity may sometimes be the better choice and less risky.
  • If the market is consistently moving up, stock selection is usually less important than buying into the market. Therefore, you may opt for buying a market ETF or index fund for higher returns and relatively lower risks.
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