Investing Fundamentals For Young Adults: Asset Allocation

Are you the parent of a young adult who has recently ventured out into the workplace? Do you want to help your children learn about investing fundamentals in order to prepare them for a healthy financial life?

When you’re in your early 20s, financial planning isn’t the first item you tend to think about. Yet for parents, it can be nerve-racking to take an unfamiliar seat on the sidelines as children graduate from college and navigate careers on their own. While it is an exciting, new chapter in life, it is only natural for parents to want the best for their children and to help them get off to a good start.

Perhaps one of the most valuable things a parent can do to help young adult children is to teach them how to develop good financial habits. But that doesn’t just mean saving and spending wisely—it also means investing for the future. By teaching your kids to invest now, you can help set them up for a financially sound future. A good place to start is with the basic investment concept of asset allocation.

To help jump-start the conversation, please see the refresher on asset allocation below.

What is asset allocation?

Asset allocation in its simplest form is how you choose to invest among various asset classes. It is a methodology that provides a framework for helping you decide which types of assets to invest in and in what proportions.

The goal of asset allocation is to strike a balance between risk and reward by constructing a portfolio of the right blend of investments that will best position you to achieve the greatest possible returns without taking on an uncomfortable amount of risk.

Why asset allocation matters

As a fundamental building block of investing, asset allocation is among one of the most important concepts for new investors to understand. A sound asset allocation strategy will help ensure that your investment portfolio is sufficiently diversified, has enough growth potential to achieve your savings goals and does not expose you to unnecessary risk.

The wrong mix of investments can significantly alter both your expected returns and potential risk exposure. When you don’t allocate enough to equities, you could miss out on growth opportunities and thus be unable to reach your goals. When you allocate too much to equities,  you could take on more risk than you want—potentially setting yourself up to lose a substantial amount of your savings without enough time to recover from your losses.

How it works

An asset is anything that has value. It could be cash, real estate or even collectible baseball cards. The investment universe is vast and wide. You can slice and dice it in any number of ways to create different categories of assets. But when it comes to investing, the three basic asset classes are: stocks, bonds and cash.

Each asset class has its own risk and reward characteristics, which means you can lessen the risk associated with any one asset class by investing in a mix of assets.

For example, you could invest all of your money in stocks, which may give you the best chance to reach your investment goals as soon as possible; however, a steep drop in the market at the wrong time could negatively impact your ability to achieve your goals. Conversely, putting all of your money into bonds or a money market account is generally much safer, especially in a volatile equity market but the downside is that you could find you need to save a lot more and need to start saving a lot earlier if you want any hope of reaching your long-term goals within a reasonable time frame.

Instead, by holding a mix of stocks and bonds, you can take advantage of the stock market’s growth potential while providing some protection against volatility with bonds.

Choosing your asset allocation

The right asset allocation for you depends on your personal preferences and goals. It is important, however, to remember that asset allocation is dynamic. The right mix of investments for you will change over time based on your evolving needs.

There are two main factors that go into determining asset allocation:

Time horizon. Generally, the longer you have to invest, the more aggressive you can afford to be with your asset allocation. If you’ll be investing for more than 20 years, you can choose aggressive investments that have high growth potential, but also higher risk. But if you know you’ll need the money sooner than that, consider your ability to withstand a bad year. The less time you have to invest, the more conservative you’ll want your allocation to be, because you won’t have the luxury of time to help ride out the storm.

Risk tolerance. How comfortable would you be if you lost a third of your money in a year? While a long-term aggressive investor might not bat an eye, not everyone has the stomach to handle a significant loss, regardless of timeline. Risk tolerance is your ability to withstand volatility. If such a loss would keep you up at night, a more conservative allocation might be more appropriate for you. By allocating more of your portfolio to cash and bonds, you can mute the impact of a volatile equity market.

In conclusion

Teaching children about important money matters can empower them to make better financial decisions down the road. It is never too late to start the conversation. If your adult children need help, they can talk to a financial professional to guide them through the process of selecting the right asset allocations.

This article was written by Halsey Schreier from Forbes and was legally licensed by AdvisorStream through the NewsCred publisher network.