Investing Step 9: Allocation

Photo by: PinkMoose

This post is step 9 in our Investing Template.

After all your tax-deferred accounts are being used to their maximum potential, it is time to fund any other accounts.  Once that is done, you need to start deciding how to allocate your funds.  This is the problem that many people did not properly address before the real-estate bubble burst and is the most important step to maximizing your returns.

Time Horizon

As we’ve discussed, the first thing you must decide in each account is how soon you will need access to the money.  You need to create an allocation based on this and adjust it accordingly.  Typically the more risky investments will even out over time and give the best returns, but can give horrible returns in the short run.  Thus the sooner you expect to use the funds, the less risky your choices should be.

For example, many people who were expecting to retire soon are suddenly in a state of confusion, because they left their investments in stocks and had massive negative returns.  This can be crippling for someone who was expecting to retire next year.  If they are expecting to retire in 20 years, there’s a good chance their investments will rebound.  However, if your time window is getting close you should be moving to safer, less risky investments, including cash.

Risk Aversion

In addition to the wisdom of avoiding risk when you are getting close to withdrawing funds, some people are very reluctant to put their money at risk at all.  If you are in this class, you should probably look to maximize your returns with very low or no-risk investments.  There are still many options available, even when capital preservation is a high concern.

The Spectrum

Here is a rough guide of some types of investments to consider, from least risky, to most risky:

•         Short Term Loans to Stable Government Entities
•         Mid and Long Term Loans to Stable Government Entities
•         Short Term Loans To Stable (Blue Chip) Companies
•         Long Term Loans to Stable (Blue Chip) Companies
•         Real Estate
•         High-Yield Debt (junk bonds)
•         Equity (Stocks and Mutual Funds)
•         Futures and Options

Real estate property has long been considered a safe investment, but recently this has been put into question.  Like any investment vehicle it is more easily navigated by experts and it is also very difficult to diversify.

Futures and options are best left to the pros.  In fact I recommend against even investing in individual stocks.  We’ll talk more about this in the next section.