When you open a managed account with an investment adviser, you generally need to fill in a questionnaire which the adviser uses to assess your risk-return profile. The key areas assessed include liquidity, risk tolerance and time horizon, but there are also other important factors, including specific tax considerations. Follow the same basic guidelines in setting up your portfolio.
As your investment time horizon lengthens, your ability to take on risk increases. This is because in the investment universe, you are compensated for your willingness to invest for longer time periods. Longer-term generally refers to investments in common stocks. You can invest in common stocks either by direct purchases of stock, through mutual funds or exchange-traded funds. ETFs offer a great option because they minimize management and transaction costs while providing much greater liquidity than mutual funds. Shorter time horizons are associated with short-term bonds, which are also available via the same investment vehicles. Again, ETFs provide the greatest flexibility.
Investors follow a basic hierarchy of risk, consisting of cash and equivalents, fixed income, preferred securities and common stock. The standard asset allocation mix recommended for long-term investors is roughly 65 percent stock, 20 percent bonds, 10 percent global equities and 5 percent cash. If your risk tolerance is lower, you might increase the allocation to bonds. Also, within the bond asset class, you could invest in bonds with lower maturities. There are many bond ETFs available that allow you high levels of customization relative to your desired level of risk.
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Liquidity refers to the amount of time required for a security's redemption and delivery of funds to be completed and occur. Cash and equivalents -- including money-market funds -- are the most liquid investments available. Publicly traded stocks and bonds are also highly liquid. Direct real estate investments are generally illiquid, but there are numerous real estate investment trusts and ETFs that allow you to invest in real estate while retaining liquidity. However, because ETFs trade publicly like stocks, their risk-return characteristics tend to mimic those of common stocks over the long term.
Other considerations may include tax constraints, legal or regulatory factors, and the timing of payouts. For example, wealthy investors are subject to higher income taxes and they therefore often allocate larger portions of their investment portfolios to municipal bonds, which are tax-free. Also, as you approach retirement, your expenses become more fixed, and the amount allocated to the bond portion of your portfolio should increase. Direct bond investments yield consistent interest income, which can be used to cover fixed costs such as rent.
Diversification should be one of the key underlying themes that you always keep in mind when considering a potential investment. Within asset class, specific investments tend to perform in line with the overall asset class, especially over the long term. Therefore, as a long-term investor you should spend less time considering investments in specific securities and more time considering asset class. Consider diversification benefits by asset class. For example, commodities offer strong diversification benefits to many asset classes. Within asset class, you can diversify by industry and other risk factors.
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