Knowing how to manage your wealth and allocate your assets is one of the most important keys to financial success and unfortunately, many people neglect this critical aspect of financial planning. As a result, the gains that they make during good times are erased when economic conditions shift and move in the opposite direction.
A classic example of that happened during 2004 – 2005 as several regions of the USA experienced home price increases of 25% or more. People witnessed those extraordinary gains and leveraged their assets to buy homes, and most of them enjoyed terrific returns over the short term. Many decided to further capitalize on the opportunity by reinvesting those robust financial profits to buy even more real estate. Then they doubled down by taking out home equity loans and spending that money without considering the risk involved if the collateral behind those loans – their own homes – lost value.
You know what happened next: Within a few months the housing market had lost its upward momentum and fallen nearly 4%. The following year home construction fell by more than 40%, while foreclosures increased by more than 40%. People who had failed to recognize the need for diversification and had invested too heavily in real estate were financially devastated. The damage soon spilled over to the whole economy, causing a widespread economic meltdown.
That’s a dramatic illustration of the fact that the same thing can happen on a micro scale to your personal portfolio unless you allocate your wealth across a healthy balance of investments.
Diversification and Liquidity
Here’s a winning approach: You want to maintain a balance between aggressive and conservative investments. Your aggression will pay off with accelerated growth when times are good. If the winds of change shift and the economy tanks, your conservative allocation will protect you from severe losses. Keeping some of your money in stocks, some in bonds, and the rest in cash allows you to take advantage of bull markets while it also gives you a safeguard against bear markets.That’s why well-managed retirement plans offer a healthy blend of stocks and bonds.
To expose your wealth to growth opportunities, invest in blue chip stocks. For steady, dependable income, buy high-quality bonds such as those backed by the U.S. Treasury. Recent news talk about a rocky market for those bonds, so always do your research before investing. To guard your cash and have it available with instant liquidity use a federally insured bank; that’s what FDIC insured means. If a bank is FDIC insured that means the Federal Deposit Insurance Corporation provides deposit insurance that guarantees the safety of depositors’ accounts in member banks. Find one near you.
Cash is King
Cash is the most conservative investment because it carries virtually no risk. The problem is that it provides very little growth. In fact, if you happen to be one of those individuals that don’t have a bank account and only carry cash, the value of that money will actually decrease over time because of the rate of inflation. The buying power of a dollar in the 1950s, for example, was much greater than it is today. A cup of coffee back then was about a dime – whereas these days it can be hard to find a cup of coffee that costs less than a dollar. There is an old saying on Wall Street, however, that “cash is king during a recession.” When a recession hits, prices go down and if you have cash, you can buy all kinds of assets at bargain basement prices. That’s the upside of holding on to your currency and why diversification of assets should always include a healthy portion of hard cash.
Historically speaking, investing in the stock market is the best way to offset the impact of inflation and to make your wealth grow faster. To improve your chances of success, however, you have to be willing to invest for the long haul. Short-term ownership of stocks usually results in lousy returns, whereas people who buy shares of well-managed companies (and hold them for many years) typically enjoy impressive gains. The nature of the markets is that they go up and down, which is why stock investors need to stay patiently invested through both bull and bear cycles.
When the stock market does fall, investors will often shift their money into bonds as a safe harbor, which makes bond prices go up in value. It’s always a good idea to balance your stock holdings with a solid bond portfolio. Another reason to own bonds is that bond prices normally move in the opposite direction from interest rates. If the interest earnings on your cash deposits (like CDs or money market funds) sink because of falling rates, the rising rates paid on bonds will balance out your returns.
No matter how old you are, it also pays to plan ahead for retirement, which presents another challenge in terms of your asset allocation balancing act. What approach should you take when adjusting the proportions of cash, stocks, and bonds as you grow older and go from aggressive growth to a safer and more secured approach? One of the best pieces of advice – and one of the easiest to remember – is to subtract your current age from 100 and then limit your exposure to the stock market to that percentage. Someone who is 25, for example, can afford to risk up to 75% of their assets by putting them into stocks, whereas a person who is 60 should not have more than 40% of their wealth invested in that way.
Tom Kerr writes for CompareCards.com in addition to others. He has been an avid writer for years, even winning awards for work he’s done.