A-Z of Personal Finance – A: Asset Allocation

We’ve all heard the phrase, “Don’t put all your eggs in one basket!” This old maxim perfectly describes the concept of asset allocation. If you put all your savings in one type of investment and the investment fails, you could jeopardize your savings. Asset Allocation refers to how you spread your money among a number of different asset classes such as cash, bonds, stocks and real estate. This strategy looks at your particular goals and circumstances and determines the most appropriate asset mix for you within the various asset classes.

The main purpose of this strategy is to reduce investment risk. History has shown that in general, various types of investments perform differently. Whilst money-market returns tend to offer low returns, your initial investment is relatively safe. Bonds may not be as lucrative, but offer more stability than stocks; they offer a middle ground between cash and stocks in terms of risk and return. Stocks, on the other hand, offer the highest return among these three classes, but they also carry the highest risk.

How much should you put where?
As you pass through your life cycle, your financial goals will change. Each investor’s approach to asset allocation will differ and depend largely upon their age, life stage, financial goals and risk tolerance. Generally, the younger you are, the more risk you can afford to take. A 22-year old just starting out in the workforce will have a completely different view of risk from a 55-year old approaching retirement. The closer you are to retirement the more important the preservation of the wealth that you have worked so hard to accumulate becomes.

Some general rules
General rules for asset allocation suggest that any money you need next year should be in cash, money you need in two to three years in fixed-income investments, and money you can afford to put away for four to five years and beyond can be invested in the stock market. This ensures that the cash you need today is readily available, the money you need in a few years’ time will be safe from stock market volatility, and money you can afford to put away for several years is invested in the stock market.

Nimi Akinkugbe is the founder and Chief Executive Officer of Bestman Games Ltd, the licensed distributor of customized editions of Hasbro’s Monopoly game for 48 African countries Nimi seeks to promote financial literacy as a tool for economic empowerment and has been a regular contributor to a host of prominent publications.

The full text appears in “A-Z of Personal Finance” by Nimi Akinkugbe. Available here.