When you’re saving for a long-term goal like retirementmost people invest their money in the financial markets, rather than just putting it in a savings account at the bank.
Because over the long term, history suggests that your money will grow faster over time if invested in financial assets such as stocks or bonds, than if you leave it in cash.
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There is, of course, a catch here.
When you put your money in cash, it doesn’t rise and fall steadily. Its value could be eroded by inflation – for more, watch our earlier video on “real returns” – but you won’t wake up one morning to find you suddenly have 10% less money in the bank than the day before.
The value of publicly traded assets such as stocks or bonds, on the other hand, fluctuates daily. In the long run, they may offer better returns than cash, but the journey will contain many more ups and downs.
Additionally, there are certain economic environments in which certain types of assets will tend to perform better than others.
So how do you balance the fact that you don’t know what’s going to happen in the future, with the need to grow a pot big enough to fund your retirement?
This is where asset allocation comes in. Asset allocation is simply dividing your portfolio between different asset classes, such as stocks, bonds, real estate, cash, and gold.
Each of these asset classes is expected to behave differently in different scenarios and offer different potential risks and returns.
The objective of asset allocation is to combine them in such a way as to produce a combined level of risk and return that best meets an investor’s needs.
Typically the younger the investor and the more time they have left before planning their retirement, the more money they will have in stocks. Stocks are the most volatile assets, but they also tend to offer the best long-term returns.
In contrast, the shorter the time horizon, the more bonds an investor can traditionally hold. Asset allocation will also consider an individual’s risk appetite – in other words, how many ups and downs they can withstand along the way.
Extended life also makes a difference. Investors looking forward to longer retirements may need to stay invested in stocks for longer than was once recommended.
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