There is a lot of jargon in personal finance, and you may have heard people talk about their asset allocations being “aggressive” or “conservative”. But what does that mean?
What asset allocation is
Asset allocation is how an investor divides up their portfolio between stocks (equities) and bonds, and also within stocks and bonds. Inside stocks, for example, there are small, medium, and large companies; US and international companies; companies that pay out dividends (value) and companies that reinvest funds back into themselves (growth); and so forth. Bonds can be government, municipal government, or corporate, as well as US and international, and can be more or less likely to default.
Since no one knows which types of stocks are going to do best in any given period, it’s a good idea to have a bit of all of them. Bonds provide a cushion against stock market drops and also some income. If you need bonds in your portfolio, it’s a good idea to spread it out among the different types, as you do for stocks.
More bonds = more conservative
In order to get a higher rate of return, you need to take more risk.
This is the risk/return tradeoff: you can’t make much money by being “safe”.
In general, having more bonds (and cash) in the portfolio makes it more conservative.
Stock prices can fluctuate intensely, and many investors find it difficult to stay invested when the stock market is dropping. Since stocks are riskier, their investors are rewarded over the long term. Frequently there are dips, corrections, and occasionally recessions, but the overall trend is to earn 6–8% over inflation over the long term (inflation is usually 2–3%). Due to the riskiness, having more stocks in the portfolio makes it more aggressive.
“Conservative” and “aggressive” might be different, depending who you’re speaking to
When clients tell me they’re conservative (or aggressive), I have to ask what that means to them. As an example, I’m in my mid-40s and my retirement portfolio is 100% in stocks. Further, my portfolio has significant weight in small cap (small company) stocks, which are more volatile than large cap. I also increased my international allocation a few years ago, including emerging markets, which are also highly volatile. By any measure, my portfolio is aggressive, and some might think it’s very aggressive.
I personally think that any portfolio with 50% in stocks or less is conservative, but someone who is a significantly more cautious investor might think 50% in stocks is aggressive. However, everyone should agree that 100% bond portfolio is conservative.
How aggressive should my portfolio be?
There are really two components in thinking about how much risk to take on.
One is time horizon, or the capacity for taking stock market risk. Over the long term (10+ years), you will make more money with a more aggressive portfolio, even when there are recessions along the way.
Investors who have a long time horizon have the time to let their portfolios recover from any recessions, so they can be more aggressive. Those who are closer to needing the money, or some portion of it, need to become more conservative so that they have some cushion against a big market drop right when they need the money.
Note that almost no one needs all their money at retirement. Many people will live another decade or two past their retirement date, which means their retirement account should still have some stocks in it to counter long-term risk, which is inflation, even when they’re retired.
The second component is more individual, as it is the investor’s tolerance for risk. Mine is very high. While you have a long-term time horizon, you’ll want to have as much stock exposure as you can stand, to capture the higher returns.
However, you don’t want to be so aggressive that you panic and sell out if the market drops for a few days, or if you can’t sleep at night worrying about it.
Allocations can be adjusted as either risk component changes
Again using me as an example, in my retirement investing right now I have a high capacity for risk (because I have a long-term time horizon) and a high tolerance for risk. My aggressive 100% stock portfolio for this goal is ideal for someone in my position.
But, when I am 5–10 years away from retirement, even if I have the same risk tolerance, I’ll need to make my portfolio more conservative because my capacity for risk has changed.
In general, being more aggressive means having more stocks in the portfolio, including stock mutual funds, and being more conservative means having more bonds and/or cash in the portfolio. The exact percentages may change according to the risk taking of the investor. One component to taking risk is the capacity, or how far away the investing goal is; the other is the investor’s tolerance for stock market fluctuations.
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Excerpted from article published on www.fabfemfinance.com.