Very simply, asset allocation is the process of deciding what percentage of your money to put in the different investment classes: stocks, bonds, money market, and other investments, such as real estate. Your asset allocation will depend on your investment time frame, your savings goal, and how much risk you are willing to take to achieve that goal.
After you decide on an asset allocation, the next step is to diversify your money within the different investment classes. By putting your money in numerous different investments, you spread the risk - rather than invest in one stock, you might invest in a variety of stocks. That way, if one stock performs poorly, it represents a smaller portion of your overall stock portfolio.
Before you can set an asset allocation and diversify your investments, though, you need to know more about the choices that are available.
Investing in stocks gives you an ownership interest in the corporation issuing the stock. If the corporation does well, your investment should do well. If not, you could lose some (or all) of your money. The advantages of investing in stocks include the potential for higher returns over time than those offered by most other investments and returns that historically have outpaced inflation. Both of these advantages make stock investments an appropriate part of a portfolio designed to achieve long-term investment goals.
Bonds and other fixed-income investments pay a set income over a set term. At the end of the term, the amount you have invested is returned to you. Fixed-income investments offer a steady income stream and historically less volatile price fluctuations than stock investments. But fixed-income investments aren't without risk. Sometimes a bond issuer, for example, can run into financial difficulties, default on its bonds, and not be able to return the face amount of the bonds to investors.
Also, bond prices move up and down, largely in reaction to interest-rate swings. Thus, investors in bond mutual funds, as well as investors in individual bonds who don't plan on holding them until maturity, face the possible risk of losing principal.
3. Money Market Investments
Like fixed-income investments, money market investments pay a defined income over a set term. (The income may be fixed or variable.) The advantage of money market investments is that many of them are backed by the Malaysian government, so return of your principal is practically guaranteed. This makes money market investments an attractive choice for investors with short-term goals. The major disadvantage of this investment class is that the investments historically have not produced returns much greater than the inflation rate.
4. Mutual Funds / Investment Linked Funds
Mutual funds or investment linked funds are one of the most popular ways to invest. With an investment fund, your money is pooled with that of other investors to purchase a variety of securities (stocks and/or bonds). The fund is professionally managed as a single investment account. Investment funds offer you automatic diversification because each fund invests in numerous different securities. When you buy units in a mutual fund, for example, you are actually buying an investment in the stocks of many different companies. If one company or industry has a problem, the fund will be less likely to suffer a major loss because it is diversified.
You can choose from various of stock, bond, balanced (stocks and bonds), and money market mutual funds. Each fund is managed toward a particular investment objective, such as growth, income, or asset preservation. The mutual fund's prospectus will explain the fund's investment objective and tell you what types of securities the fund can hold.
When choosing investments, potential return is a key consideration. The higher your return, the faster your investments will grow and the sooner you will reach your goal. But be aware that the annual percentage returns and yields you see published in ads, prospectuses, and articles don't take into account inflation or taxes, two factors you need to consider in your investment planning. And the higher the potential returns also mean a higher investment risk.
You also need to weigh an investment's risk. Generally, the more risk involved with an investment, the higher its potential return. Consequently, the more risk you are willing to take, the more potential your savings have to grow over the long term. Before choosing an investment, you should make sure you understand the investment, the risk it carries, and how that risk relates to your investment goal.
For instance, if you are investing for your two-year-old child's college education, you can probably afford to assume more risk in your investing than someone whose child will begin college in two or three years. With more than 15 years before you'll need your money, you should have time to make up any short-term losses your investments may experience. Of course, there can be no assurance that any losses will be made up in a 15-year time period.
Short-term investments, such as money market funds, offer the least risk. Fixed-income investments offer potentially higher returns with added risk. Stock investments offer the highest potential returns with the greatest amount of risk. A combination of money market, fixed-income, and stock investments can provide potentially higher returns than either money market or fixed-income investments alone, with only slightly greater risk.
As you near your goal, your risk tolerance may drop and you may want to change your asset allocation. Protecting and preserving your savings might become more important. You may be willing to give up the growth potential of most of your long-term investments in favor of the greater security offered by short-term investments.
Modern Portfolio Theory
The above is part of the application of Modern Portfolio Theory, a sound method for many investors to establish a disciplined approach to investing.
When you put all this together, it's entirely possible to build a portfolio that has much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you're really just managing risk and return.