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A Quick Guide to Asset Allocation: Stocks vs. Bonds vs. Cash
Knowing how to properly allocate your investment portfolio can help you meet your goals and manage your risks.
You have three main choices when it comes to investments in a brokerage account or retirement plan: stocks, bonds, or cash. There is no one-size-fits-all answer to the question of proper asset allocation, and your ideal mix depends on your age, risk tolerance, and time frame until retirement. Here’s a guide to help you make the best decisions for the asset mix in your portfolio.
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How much of your assets should be in stocks and bonds?
The answer to this question depends on a few factors. Most important is your age — you should keep more of your assets in stocks while you’re younger and have decades to ride out volatility and take advantage of the compounding power of stocks. As you get older, you should begin shifting some (but not all) of your assets into bonds, which are generally lower in volatility and produce consistent, reliable income.
As a general rule of thumb, subtract your age from the number 110 in order to determine your target stock allocation. For example, if you’re 35, this rule says that approximately 75% of your assets should be in stocks.
Of course, some investors have a higher-than-average appetite for risk, while others place more emphasis on avoiding market fluctuations and preserving their capital. If you feel comfortable taking a little more risk in exchange for the potential of higher long-term returns, you may want to substitute 120 for 110 in the allocation formula, resulting in a higher stock exposure.
On the other hand, let’s say that you’re 55 and want to retire early. You have almost enough money to live a comfortable life in retirement, so your main goal is simply not to lose money. In this case, you can use 100, or even less, to determine the proper stock allocation for your age.
The point is that there’s no simple answer. To further complicate matters, there is a wide variety of risk within stock investments. Speculative stocks and established blue-chip companies are two entirely different things, so we’ll discuss that in more detail later on.
How much of your assets should be in cash?
The short answer: not much. A more thorough answer is that you should have a good amount of cash in a readily accessible place such as a savings account. Experts generally recommend that you aim to have six months’ worth of your living expenses in a cash account, in order to be able to cover unforeseen expenses without tapping into your investments, borrowing the money, or selling something.
Provided that you have some sort of emergency fund, we think that 100% of your investment accounts should be in stocks and bonds. That’s not to say you should take risks with all of your money — there are certain types of bonds (short maturity and high quality) that aren’t much riskier than cash and pay significantly higher interest rates than the average savings account.
It’s important to mention that when we say “cash,” we’re referring to actual cash and similar investments such as money market accounts.
Having said all of this, if you need capital preservation (if you’re already retired, for instance), it’s completely fine to keep a small percentage of your investment assets in cash if you don’t feel comfortable being fully invested in stocks and bonds.
What kind of stocks should you own?
When it comes to investing in stocks, whether you plan to choose individual stocks or buy mutual funds or ETFs, you have a lot to choose from. You can pick value stocks or growth stocks, large-, mid-, or small-cap stocks, international or domestic stocks, and stocks on all levels of the risk spectrum. Here are a few basic definitions you should know and then we’ll discuss how you can figure out your stock allocation.
- Value stocks — Companies with solid fundamentals that are perceived to trade at a discount to peers. A value mutual fund’s objective is to identify and invest in a variety of undervalued stocks, with the goal of producing market-beating returns over time.
- Growth stocks — Companies with faster-than-average growth as measured by revenue or earnings. A growth fund’s objective is to identify and invest in the best growth stocks. Generally speaking, growth investing represents a higher level of risk than value investing.
- Large-cap stocks — The exact definitions vary depending on whom you ask, but a large-cap stock is generally considered to be one with a market capitalization of $5 billion or more.
- Mid-cap stocks — Companies with a market capitalization between $1 billion and $5 billion.
- Small-cap stocks — Companies with a market capitalization less than $1 billion.
If you plan to invest in mutual funds, here are a few more definitions you should know:
- Index fund — A fund that tracks an underlying index. As opposed to an actively managed fund, whose managers pick stocks with the goal of beating an index, an index fund simply buys all of the companies in the index in order to match its performance. For example, an S&P 500 index fund would buy the 500 stocks that make up the S&P 500 index.
- International fund — A fund that invests in companies based outside of the U.S. This is not to be confused with a global fund, which invests in stocks from markets all around the world, including the United States.
If you decide to invest in individual stocks, it’s a good idea to choose at least 15-20 stocks across a variety of sectors, and a few from each major category above (growth/value, large/mid/small). The majority of your holdings should be in larger, established companies, but diversification is the most important point.
Also on the concept of diversification, if you plan to invest in mutual funds, it’s important to spread your money around. A broad index fund, such as one that tracks the S&P 500, is pretty diverse, but it’s also a good idea to get some exposure to small caps and international stocks.
In a nutshell, there’s no way for us to tell you exactly what your stock portfolio should look like, but as long as you diversify and stick mainly to stocks (or funds) that have a proven record of success, you should be just fine.
Bonds: Funds are the way to go (for most investors)
There are plenty of different choices when it comes to bonds. You can choose government bonds such as treasuries, municipal bonds, or corporate bonds. Within each of those categories, there is a wide variety of maturities to select from, ranging from a matter of days to 30 years or more. And there is a full range of credit ratings, depending on the strength of the bond’s issuer.
Fortunately, for the majority of investors, a bond-based mutual fund or ETF is sufficient to meet their needs. Remember that the main reasons for allocating a portion of your portfolio to bonds are to offset the intrinsic volatility of stocks and produce a reliable stream of income — not to produce long-term compound growth or beat the market. Therefore, a bond fund or two that fits your risk tolerance is really all you need. Vanguard’s Total Bond Market Fund is one good example of a diversified, low-cost option.
Target-date retirement funds: Automatic asset allocation
No discussion of asset allocation would be complete without mentioning target-date retirement funds and whether they are good choices for your investment portfolio.
A target-date retirement fund (also known as a lifecycle fund) is a form of mutual fund that invests in a combination of stocks and bonds, gradually shifting its asset allocation from stocks to bonds as the target date approaches, and beyond. For instance, a target-date fund intended for people retiring in 2055 might have 90% of its assets in stocks and 10% in bonds, while a fund intended for 2020 retirees may have a 50-50 mix. The exact mix depends on the particular fund company, but the idea is the same.
At The Motley Fool, we’re obviously in favor of choosing individual stocks, as long as you have the time and desire to properly research investments. Having said that, if you prefer a hands-off approach to investing and don’t want to worry about shifting your asset allocation as you get older, a low-cost target date fund can be a good option. Here’s a thorough discussion about target-date funds if you’re interested.
The bottom line on asset allocation
While there is no one-size-fits-all asset allocation strategy, by analyzing your personal situation you can determine the best asset allocation for you. Doing so can get you the right combination of growth and income, while still allowing you to sleep at night.
Explaining The Capital Asset Pricing Model (CAPM)
No matter how much you diversify your investments, some level of risk will always exist. So investors naturally seek a rate of return that compensates for that risk. The capital asset pricing model (CAPM) helps to calculate investment risk and what return on investment an investor should expect.
Systematic Risk vs. Unsystematic Risk
The capital asset pricing model was developed by the financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book Portfolio Theory and Capital Markets. His model starts with the idea that individual investment contains two types of risk:
- Systematic Risk – These are market risks—that is, general perils of investing—that cannot be diversified away. Interest rates, recessions, and wars are examples of systematic risks.
- Unsystematic Risk – Also known as “specific risk,” this risk relates to individual stocks. In more technical terms, it represents the component of a stock’s return that is not correlated with general market moves.
Modern portfolio theory shows that specific risk can be removed or at least mitigated through diversification of a portfolio. The trouble is that diversification still does not solve the problem of systematic risk; even a portfolio holding all the shares in the stock market can’t eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what most plagues investors.
The CAPM Formula
CAPM evolved as a way to measure this systematic risk. Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relationship between risk and expected return.
Here is the formula:
CAPM’s starting point is the risk-free rate–typically a 10-year government bond yield. A premium is added, one that equity investors demand as compensation for the extra risk they accrue. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called “beta.”
Beta’s Role in CAPM
According to CAPM, beta is the only relevant measure of a stock’s risk. It measures a stock’s relative volatility–that is, it shows how much the price of a particular stock jumps up and down compared with how much the entire stock market jumps up and down. If a share price moves exactly in line with the market, then the stock’s beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%.
Beta is found by statistical analysis of individual, daily share price returns in comparison with the market’s daily returns over precisely the same period. In their classic 1972 study “The Capital Asset Pricing Model: Some Empirical Tests,” financial economists Fischer Black, Michael C. Jensen, and Myron Scholes confirmed a linear relationship between the financial returns of stock portfolios and their betas. They studied the price movements of the stocks on the New York Stock Exchange between 1931 and 1965.
Beta, compared with the equity risk premium, shows the amount of compensation equity investors need for taking on additional risk. If the stock’s beta is 2.0, the risk-free rate is 3%, and the market rate of return is 7%, the market’s excess return is 4% (7% – 3%). Accordingly, the stock’s excess return is 8% (2 x 4%, multiplying market return by the beta), and the stock’s total required return is 11% (8% + 3%, the stock’s excess return plus the risk-free rate).
What the beta calculation shows is that a riskier investment should earn a premium over the risk-free rate. The amount over the risk-free rate is calculated by the equity market premium multiplied by its beta. In other words, it is possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a stock is consistent with its likely return.
What CAPM Means for Investors
This model presents a simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory. But does it really work?
It’s not entirely clear. The big sticking point is beta. When professors Eugene Fama and Kenneth French looked at share returns on the New York Stock Exchange, the American Stock Exchange, and Nasdaq, they found that differences in betas over a lengthy period did not explain the performance of different stocks. The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong.
While some studies raise doubts about CAPM’s validity, the model is still widely used in the investment community. Although it is difficult to predict from beta how individual stocks might react to particular movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than the market in either direction, and a portfolio of low-beta stocks will move less than the market.
This is important for investors, especially fund managers, because they may be unwilling to or prevented from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead. Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold securities with betas in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is falling.
Not surprisingly, CAPM contributed to the rise in the use of indexing–assembling a portfolio of shares to mimic a particular market or asset class–by risk-averse investors. This is largely due to CAPM’s message that it is only possible to earn higher returns than those of the market as a whole by taking on higher risk (beta).
The Bottom Line
The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It provides a useful measure that helps investors determine what return they deserve on an investment, in exchange for putting their money at risk on it.
Thread: What is capital Asset Pricing Model?
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What is capital Asset Pricing Model?
I have read it some where can anyone please elaborate it for me?
The capital asset pricing model describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital. Investors expect to be compensated for risk and the time value of money. The other components of the CAPM formula account for the investor taking on additional risk. The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one.
The CAPM Capital Asset Pricing Model is a model that is used in the Investments world to refer to how the risk involved in making an investment in a security is related to the possible profits that is expected to be derived from the said Investment. The CAPM has a formula for it’s Calculation and this is given as
Expected Returns = Risk free rate + (beta × market risk premium)
So it is this formula that is used to calculate for the returns that is expected from an investment. It is very important that the CAPM is assessed by an investor before investing in an asset so that the investor will be sure of what amount of risk is present in the Investments and what is the possible amount of returns that he could get from the Investments.
There is a saying that before you build a house you sit down first and count the cost to know if you will be able to finish the project. Capital Asset Pricing Model (CAPM) is a model that informs an investor the risks involved if he decides to invest in an asset and the possible returns too. In a situation where the investor decides to invest on the asset, he or she expect to be compensated. In calculating CAMP to know the risk involved in an asset, when the beta is above 1 the risk is considered to be on the high side but when the beta is below 1, it means the risk is low. One of the problems investors have with CAPM is that it is based on assumptions and it does not hold water when applied in a real life situation. Despite this noticeable problem it is still being used by investors because of its simplicity.
Capital asset pricing model also known as CAPM suggest a kind of model designed for use in the financial world and other economic related concepts which is used to determine the fair rate of return on certain asset. The model is a very effective one and on the long run can assist an investor or trader in decision making process over selecting an asset which has a profitable outlook. One thing worthy of note in the financial world or when investment is concerned is that proper planning is done, to at least arrive at a possible future result of whatever it is a person or busijessris getting into. Capital asset pricing model (CAPM) properly fits in for a model that can be used to calculate and achieve what the possible outcome of an investment or asset would be, which will then prompt the decision of an investor to take such asset into consideration or not.
Every business though with the aim of making profit goes along with all manners of risk which is expected to be well evaluated and effectively managed.In this case it is advisable for investors or analysts to be able to quantify all the risks and at the same time weigh it side by side with the anticipated rewards.In the world of finance there are different types of tools (mathematical,statistical,accounting,economic etc) that are widely used of which Capital Asset Pricing Tool (CAPM) is one of them.Capital Asset Pricing Model (CAPM) is a tool or model that fully describes the relationship between the associated risk in a business and the expected return or a reward.It helps the investor to be certain of what to be expected
The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.
Expected return = Risk-free rate + (beta x market risk premium)
Using the capital asset pricing model, the expected return is what an investor can expect to earn on an investment over the life of that investment. It is a discount rate an investor can use in determining the value of an investment. The risk-free rate is the equivalent of the yield of a 10-year U.S government bond, though if the calculation is being done in another country, it should use that government’s 10-year bond yield.
The Capital Asset Pricing Model (CAPM) refers to a framework that outlines the similarity between the proposed outcome and risk of investing in an asset. It presents that the expected outcome on an asset is the same to the risk free outcome and a risk premium, which is established on the beta of that asset. The capital asset pricing model formula is deployed when calculating the expected results of a security. It is accorded to the idea of standardized risk and that traders are expected to be reimbursed for it in for a debt premium. The CAPM comes with various benefits such as; it makes use of specifically a methodical risk, showing a sensibility in which most traders have an assorted portfolio from which non-standardized risk has been primarily removed. Another advantage of CAPM is that it is hypothetically-formed association between required return and systematic risk which has been a case for routine experimental analysis. And lastly, it is basically regarded as a preferable approach when it comes to calculating the cost of equity compared to dividend growth model.
The Capital Asset Pricing Model (CAPM) portrays the connection between methodical risk and anticipated return for resources, especially stocks. CAPM is generally utilized all through account for estimating dangerous protections and producing expected returns for resources given the danger of those advantages and cost of capital. A financial specialist can likewise utilize the ideas from the CAPM and proficient wilderness to assess their portfolio or individual stock execution contrasted with the remainder of the market. For instance accept that a financial specialist’s portfolio has returned 10% every year throughout the previous three years with a standard deviation of profits (risk) of 10%. Be that as it may, the market midpoints have returned 10% throughout the previous three years with a danger of 8%.
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