When saving for a long-term goal such as retirement, many people invest their money in the financial markets, rather than simply putting it in a bank savings account.
Because in the long run, history suggests that your money will grow faster over time if it is invested in financial assets such as shares or bonds, than if you leave it in cash.
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There is, of course, a hitch here.
When you put your money in cash, it doesn’t go up and down on a regular basis. Its value can be eroded by inflation – for more on this, see our previous video on “real earnings” – but don’t wake up in the morning to find you suddenly have 10% less cash in the bank than you did earlier. day.
The value of publicly traded assets such as stocks or bonds, on the other hand, fluctuates on a daily basis. In the long run they may give better returns than cash, but the journey will have many more ups and downs.
Also, there are certain economic environments in which certain types of assets tend to do better than others.
So how do you balance the fact that you don’t know what will happen in the future, with the need to grow a pot that is big enough to fund your retirement?
This is where asset allocation comes into play. Asset allocation is simply the process of dividing your portfolio between different asset classes, such as shares, bonds, property, cash and gold.
Each of these asset classes should behave in different ways in different scenarios, and offer different risks and potential returns.
The aim of asset allocation is to mix them together in a way that produces a combined level of risk and return that best suits the investor’s needs.
Typically, the younger the investor and the longer they have until they plan to retire, the more money they have in shares. Shares are the most volatile assets, but they also tend to give the best long-term returns.
In contrast, the shorter the time horizon, the more bonds an investor may have traditionally held. Asset allocation will also take into account an individual’s appetite for risk – in other words, how much they can feel down the road.
Life expectancy also makes a difference. Investors looking ahead to a longer retirement may need to stay invested in stocks longer than once recommended.
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