How the heck are you supposed to judge whether a specific asset allocation is right for you if you don’t fully understand the differences between the assets you are allocating? What does that even mean?! What is an asset and how can I get one may be your first question. Let’s start at the beginning so you can understand what your financial adviser, financial planner or salesperson (let’s be real - most people in “financial services” are actually in “financial sales”) is talking about. Today let’s focus on empowering you with knowledge you can use to better understand your financial picture. I’ll be frank, I don’t think the vast majority of people should be creating custom asset allocations. In fact, I discourage that idea. But, whether you know it or not, you’re probably already making asset allocation decisions. Even NOT making a decision is actually making a decision, in a twisted, Alice in Wonderland sort-of way. Your 401(k) investment selections, how much cash you hold, if you invest in rental real estate, etc. are all asset allocation decisions. You don’t need to be an expert in asset allocation, but you do need a basic understanding. We will cover some of the major asset classes along with a couple of popular “asset classes” that some financial salespeople love to sell. Let’s start at the beginning…
Cold, Hard CashCash? Everyone knows what cash is, right? I’m here to tell you that when you are speaking to someone about your investments there are (at least) two types of cash. And I’m not talking about bitcoin. To begin with, there is the standard cash. We will refer to this as FDIC-insured cash. It’s the same as the cash you keep in your banking account and it probably isn’t earning diddly right now. The good news is that, as long as you are under the FDIC insurance limits, you will get your money back - even if the bank that holds your money goes under. The other common type of “cash” you will see is called a money market. A money market account is technically an ultra-short term bond account. That means that all of the bonds will mature within 12 months. This was considered to be a fairly risk-free, boring asset class until, oh...2008 when Lehman Brothers (a well respected financial services company) went under. (For the super nerdy or history buffs you may enjoy this.) The SEC recently put new rules into effect that can limit investors ability to withdraw their money from these prime and municipal money market funds, or pay a 2% redemption fee during periods of market stress. Which is why many retail investors (us) are being pushed into money market funds that hold very liquid U.S. federal debt. These federal money market funds do not have the same restrictions as Prime and Municipal money market funds. They also pay less in interest. As always, check the fees charged on these options as you may be paying for the privilege of parking your cash there. If the return or current interest rate is less than the expense ratio (the fee you pay), you are paying the fund company to hold your money.
Stable Value - sounds nice, what is it?You may also have a Stable Value fund that offers a hybrid of insurance and bond investments to provide you with a guaranteed rate of return. Typically the return on these types of funds is slightly higher than cash. Pay close attention to the fees on these investment options. They can quickly wipe out your returns in a low interest rate environment (such as the one we are in experiencing in early 2017). You should also consider your time horizon. If you are quite a ways from retirement (10 years+) you may wish to have your retirement account fully invested (i.e. not hold significant cash or cash-like assets).
Bonds - your buoy in rough markets?Bonds, also known as fixed income, can provide investors with income in the form of interest payments and, ideally, principal protection. Think of bonds as loans. If you own a bond or bond mutual fund you are actually the lender. The bond “issuer” is the borrower. Businesses, states, municipalities and foreign governments (among others) can all issue bonds. Some people think that it’s not possible to lose money on bonds Those people are wrong. However, the magnitude of loss on investment grade bonds compared to stocks is typically much lower. “Investment grade” means that the likelihood of the borrower being repaid is pretty high. Here are some of the types of bond funds you may have access to:
- Short Term Bonds: these bonds mature (pay back their principal or pay back the loan) within 3 years.
- Intermediate Term Bonds: these bonds tend to mature in 3-10 years.
- Long Term Bonds: these bonds mature in longer than 10 years.
- High Yield Bonds: also known as “junk debt” has a credit rating below investment grade which means the odds are higher that the lender (you, if you own these) won’t be paid back. High yield bonds generally pay a higher interest rate (to compensate you for their risk) and tend to behave more like stocks.