When it comes to allocating your assets properly, beware the 4 most common mistakes and see how to avoid them. While many of us may understand the basic principals behind asset allocation – when you can afford risk go for riskier stocks, when you need to preserve your capital keep your money in cash and safe bonds – but it is the over-simplification of proper asset allocation in relation to your personal finances that can lead to some serious investing mistakes. Below we outline the 4 major mistakes either investors or financial advisors can make when allocating assets.
1. Misunderstanding Your Actual Appetite for Risk
Both culturally and from an investors perspective we are bred to believe no risk equal no reward, so naturally the question of “How much risk can you handle?” gets translated to “How much money would you like to make?”. This of course leads people to make somewhat riskier choices. But the market isn’t designed to let everyone win – when you sell a stock it’s because someone else out there thinks that purchasing it is good value for their money, with each one thinking “haha, sucker” as they walk away from the transaction. You need to weigh your assets appropriately for the level of risk you can actually afford. When you invest in medium or small sized stocks you need to ask yourself “I am actually okay financially if these investments drop 50% in value?” If you’re not, then stick to safer stocks.
2. Confusing Your Personal Feelings of Risk With Your Situation
Effective personal finance is not just about where you are, but where you want to be. Just because you’re 15 and scared of taking chances or 70 years old and have a live-on-the-edge instinct, your actual risk profile may not match your attitude. This is because for many of us we simply don’t know what kind of risk makes sense given our personal financial circumstances. Much like the first mistake was confusing risk with reward, too often investors confuse their personal desire for risk (I like to go skydiving) with their portfolio’s ability to actually handle the risk you want to take with it.
3. Keeping Too Much of Your Assets in Cash
For those that want security in their portfolio, cash is not the way to go. High yield savings accounts along with treasury, Government and secured banking bonds are the way to go. Why? Because for the same level of risk (as close to zero as you can get) you can instead earn 3-5% on your money instead of the 0.5% earned by keeping it in a checking account. There is an estimated $900 billion sitting in checking and low-yield savings accounts in theUS. How tragic.
4. Putting All of Your Assets into Alternative Investments / Real Estate
Real Estate is not different from investing in the market. You evaluate properties much like companies, you look at the industry, the rents you can get and you make a decision to buy. The problem here is that many folks will save up $50k and then decide to put all of it into a home to be used as an investment. While real estate can be a valuable long term investment and provide a steady cash flow in good times, it should be part of an overall intelligent investment strategy before you take the leap. For one, it comes with extraordinary risk, as illustrated by the recent collapse of the housing market in theUS. But the second and perhaps most significant part of real estate investment is that it usually doesn’t diversify your assets and thus compounds the risk. For example, if you live inBostonand by a condo inBostonto rent out, if the job market in that city goes south both your job AND your condo are at risk. As the economy goes south more and more layoffs occur, which drives down the price of houses and many look for cheaper and cheaper places to rent – if you yourself are a victim of the downturn you’ll be hit twice. The alternative to this is to obviously put your money somewhere that mitigates the risk if your job and/or industry go belly up. By the same reasoning, don’t put all your money in gold if you work for a gold company.
To understand what your risk profile looks like try our free asset allocation tools to get an idea of the level of risk you can take on and where you should be putting your money.
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