Which stocks should you buy? When you've got money for investing, that question seems like THE most important one. But before you buy your first investment, take a step back and ask yourself a different question first: How comfortable are you with risk? Asset allocation balances the amount of risk you take with the amount of return you earn and helps you answer that question.
Here are four common asset allocation mistakes and how you can avoid them.
1. Not having a plan
You have your overall investment objectives, but each of your accounts needs a goal, too. A study conducted by Harvard showed that people who made written and verbal plans achieved their goals ten times more often than those who did not. Your investment planning starts by deciding the purpose of your investment and when will you use it.
Are you investing for a down payment on a house in five years? Your child's college education in ten years? Retirement in 20 years? Your individual account goals, and the time horizons associated with them, are important factors in how much risk you take on. By taking this first step and designating an endpoint, you can map out the best asset allocation for reaching that endpoint.
2. Being too aggressive or too conservative
You usually think of asset allocation in its simplest form -- a mix of stocks and bonds. Asset allocation affects your account's volatility and performance, and how much you own of each decides how conservatively or aggressively you invest. If you invest too conservatively, your accounts won't grow well. You might even find yourself disappointed each year with your returns when you review your accounts.
If you're too aggressive, you won't be able to withstand the fluctuations in your account. Your emotions may end up getting the best of you, and instead of investing long-term, you'll find yourself selling out of your portfolio when the markets crash and buying back in when they rebound. These attempts at market-timing could also worsen your returns.
You can avoid this mistake by completing a risk tolerance questionnaire. It will factor in things like your income and access to cash outside of your investments. It will also take into account your feelings about market volatility and your past reactions to it. The better you align your investments with your comfort level with risk, the more likely you are to meet your goals.
3. Concentrated positions
Do you have one company stock that makes up the majority of your accounts? Have you found yourself overly excited about a sector and increased your exposure? Here, "a concentrated position" means you've placed too many of your eggs in one basket.
Sure, your concentrated risk may pay off big time – but if that particular stock or sector performs badly, you stand to lose a lot. Year to date, the S&P 500 is up around 3.4%, but energy stocks are down more than 35%. If you had more exposure in this sector, your accounts would have suffered more than if you maintained an even mix of stocks across all sectors.
Experts say that a single position shouldn't make up a significant portion of your investment holdings. The precise number for "a significant portion" differs for everyone. When you're deciding what it means for you, ask yourself this question: would you be as OK with a big loss as you would with a big gain? If the answer is no, you should focus on diversification.
4. Focusing on stocks and bonds in general
Stocks are diverse. You can choose between value or growth, small-cap or large-cap, and international or domestic. You can buy bonds based on credit quality or duration. Each category carries its own risk-versus-reward trade-off.
For example, smaller companies are riskier, but historically they have performed better than large companies over long periods of time.
To maximize your returns, you'll want some exposure to all of these categories. How much you have in each will depend on your asset allocation model. If you have an aggressive portfolio, you can have more exposure to riskier stocks with higher returns than if you have a conservative portfolio. If your portfolio is invested for a longer period of time, you can invest in bonds that will provide you with a higher yield than someone with a short-term portfolio.
Asset allocation is more than just an investment buzzword -- it is the driving force behind your account performance. When your asset allocation doesn't match up with your risk profile, your investment performance suffers. Reaching your investment goals will depend more on getting your asset allocation right than on picking the right stocks. Avoiding these mistakes is the key to ensuring that success.