1. What is asset allocation?
All investors must determine how they should divide their cash. Putting more money in fixed income than stocks, or in Canada versus overseas, will have an impact on both risk and reward. It's a good idea to talk to an adviser if you're not sure how much risk you want to take on. Asset allocation is exactly what you think it is -- it's determining where you allocate the money in your portfolio.
2. Why is asset allocation important?
The primary reason you need to seriously consider your asset mix is because of the importance of diversification. Generally, the more diversified your investments are, the less risk to your savings. If you only invest in one sector, or one type of security, your investments are more volatile and you have a greater risk of big losses.
3. What are the main asset classes?
Assets are typically divided into three classes: stocks, bonds and cash. Stocks are shares of companies that trade on a stock market; bonds are shares of debt issued by a company that pay interest; cash is, well, cash.
Some people consider real estate -- literally, property -- and commodities (oil, gold, cotton, etc.) asset classes as well. On the risk scale, stocks are the most volatile, bonds are less risky and cash, which just sits in a bank account, is the safest in terms of preserving your principal.
4. How do we choose investments?
Part of this process is also choosing what types of investment you want to own: for instance, options could include mutual funds, exchange-traded funds, stocks or bonds. You might want a few mutual funds and a couple of ETFs, or all stocks. Balanced mutual funds own some stock and some bonds, so the asset mix is predetermined. Or you can choose your own adventure and buy 70 per cent stocks and 30 per cent bond funds. Your choices depend on your risk tolerance and, partly, whether you want to leave your assets with a manager or invest yourself.
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5. Should we be investing in Canada or overseas?
The geographic location of your assets is also important. Some people like keeping their money in Canada -- it's easy to understand and our country's economy has been doing well. But our market's not diversified enough to provide investors with a truly diversified portfolio -- we have a high concentration of resources and financials -- so if you really want to spread your assets around, you may need to buy some American funds. If you want some growth, consider emerging markets like China or India, whose economies are growing faster.
6. What about allocating assets by sector?
Choosing a sector -- the type of industry and company you're investing in, such as finance, technology or natural resources -- is also part of asset allocation. Each sector has its own risk and reward characteristics and there are many subsectors that offer even greater -- or worse -- returns. If you buy a Canadian or American equity fund, the portfolio manager does all the work for you. Their job is to determine where the best (but least risky) buys are. If you're a stock picker you'll have to determine how to split your assets between industries yourself.
7. How to get started with asset allocation
Most investors won't have to worry too much about asset allocation -- again, buy a few broad funds and you should be OK. But you still need to know how it works. Let's say you buy a Canadian equity fund, which is 100 per cent invested in Canadian assets. But you really think the financial industry is going to take off next year. You're not a stock picker, but you bank at TD, so you want to own a few of its shares in addition to the other funds you own. It's likely the Canadian equity fund you're invested in already owns TD, not to mention BMO and CIBC and other Canadian banks. So should you still buy TD? Probably not -- you'll then be too concentrated to the financial sector.
Here's another scenario. You want to buy three investments, a Canadian, a U.S. and a global equity fund. Sounds like you'll be well-diversified, right? But what if the global fund owns a lot of U.S. stock? If you buy the U.S. equity fund, you'll likely be too concentrated in American companies. Instead, make sure the international part of your portfolio is actually invested in overseas companies.
When it comes time to pick your asset allocation mix, you'll likely start with asset class, then location and then sector, or the type of bond if you're talking about fixed-income. Some advisers only talk about asset mix in terms of investments; others look at all your finances and include things like the business you own, the Florida condo you bought last year, the cottage up north and more. The ultimate goal, especially for retirees, is to stay diversified and make sure your portfolio is well-protected. So never ignore your asset mix.
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