At its foundation, asset allocation is about dividing your wealth up into different baskets so that you do not sustain a large loss. If we go back to what we learned in Section 1, we see that there are several categories of investments and many, many variations within those categories. Let’s recap the most salient features of each:
Cash. Cash (or “cash equivalent”) provides savings options that are liquid. I recommend keeping your emergency fund in a bank account where you have instant access; this is because of the very nature of an emergency. You can also make cash beyond your emergency fund a part of your investment account. Many investors refer to a cash reserve in an investment account as “dry powder.” This money is reserved for situations where making a particular investment at a particularly opportune time can result in a very large upside.
This is a very good idea for a trader, but its uses for investing as suspect. Holding a lot of money in cash for a long time causes you to lose money due to “opportunity costs” and inflation. Inflation kills the value of your cash any time the interest rate is less than the inflation rate. Note that short-term treasuries are often considered as “cash” as well as bonds. Since they expire in a year or less, short-term bonds (and associated bond funds) don’t have much interest rate risk and thus pay low rates of interest.
Bonds. Bonds are debt sold to private individuals with a promise to return the borrowed money plus interest. Many think that there is a nearly perfect negative correlation between stocks and bonds, such that when stocks go down in value, bonds automatically go up. This is not true! Talk to a diversified investor that survived 2008, and they can tell you that both can down substantially at the same time. There is a negative correlation, but it is far from perfect. Simply put, bonds are not a complete hedge against stock declines.
Not all bonds are created equal. As with everything on Wall Street, you are paid to take risk. Government bonds pay the least interest because they are generally the safest bets. Huge companies like General Motors and Apple pay a little better than Uncle Sam, but not by a huge amount. People know that these behemoths are not going anywhere.
The key economic indicator that influences bond prices is the prevailing interest rate. That is, bond prices tend to seesaw with interest rates. When interest rates are going lower, bond prices go up. When interest rates are rising, bond prices go lower. At the moment, Fed policy is to slowly raise rates over the next few years. This will provide a sustained headwind for bond prices, so you are not likely to see the generous bond price moves that we’ve seen in the past decade.
CDs. Certificates of Deposits are you loaning the bank money for which they will pay you the going rate plus a little extra since the money is tied up for a long time. CDs have a bad reputation these days. This is not because they are a bad instrument; they just do not perform well under current economic conditions. When interest rates climb substantially, then take another look at CDs.
Stocks. Stocks are little parts of companies. You make money from owning a stock when the company pays dividends to shareholders, and you can make money if the price of the stock goes up in the stock market. Different types of companies will provide different results; old companies that are huge but not growing much tend to pay good dividends, while smaller newer companies tend to be fast-growing but pay small or no dividends at all.
Last Updated: 6/25/2018