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Creating Your Financial PlanPart 2, Asset AllocationIn Part 1 of Creating Your Financial Plan: Long-Term Investing, we saw the importance, even the need, of investing to bring your goal of financial independence to fruition. We discussed the differences between saving and investing, along with their relationship to one another. We also looked at the priorities of short- and long-term goals in your investment program. In this article we’ll see the types of assets that you can invest in, as well as examples of how they can be allocated in your portfolio to help you obtain your financial goals. The most critical step in creating a long-term investment program is to allocate your assets by striking a balance that meets your needs among the three common investment classes:
Common stocks have historically delivered the highest annual returns of the three investment classes. In fact, the average annual rate of return for stocks from 1926 to 1996 was more than 10%. Bonds had an average return during that time of just over 5%, while the average return on cash reserves was just under 4%. However, while stocks and bonds do offer the potential of higher returns than cash reserves, they also expose you to more risk. This is the classic investment trade-off; in order to pursue higher investment returns, you must be willing to assume higher risk. How you allocate your investment funds among stocks, bonds, and cash reserves depends upon four factors: 1) your financial situation, 2) your objectives, 3) your time horizon, or the time period that you have to invest, and 4) your ability to tolerate risk. Of these four, time is perhaps the most important factor. The longer you have to invest, the longer you have to accumulate wealth and the greater the risk you should be able to assume. If you’re investing for your child’s college expenses, your objective when you child is young should be to achieve maximum growth of your money. Then, when your child enters college, you need ready access to your cash as various bills become due. At the same time, your education fund should continue to earn a reasonable rate of return. With these objectives in mind, your asset allocation for college investments should emphasize stocks during your child’s early years, and then turn more conservative as he or she enters their teen years. As college arrives, your investments should consist mainly of money-market vehicles and short-term bonds for liquidity. In many ways, investing for retirement is similar to investing for college. The time that you have to invest is, of course, much longer. For retirement, your objective during your working years should be to accumulate assets by emphasizing growth. Because of the long time horizon, you have the time to take measured risks. After you retire, you should be more concerned with preserving the money that has built up and spending it to support your lifestyle. At that time, your investments should emphasize income, with some growth in order to offset inflation. As with college investing, your asset allocation for retirement should emphasize stocks when you’re young and move gradually to bonds and cash reserves as you grow older. But you’ll always want to keep a separate savings fund reserved for emergencies and short-term objectives.
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