What is asset allocation?

Definition and Example of Asset Allocation

Types of Asset Classes

How Does Asset Allocation Work?

Asset Allocation and Your Goals

Asset Allocation vs. Diversification

Why is Proper Allocation Important?

Definition and Example of Asset Allocation

Asset allocation involves diversifying your investments across a variety of different asset types. This helps protect you from large losses in your portfolio. Asset allocation is a fundamental part of any investment strategy. Your portfolio should be diversified, and how you allocate your assets is part of how diversified you are. Each of these asset classes reacts differently to changing market trends, so having a mix of them in your portfolio helps reduce losses in the event of a market downturn.

For example, suppose an investor is about to enter retirement and currently has an asset allocation of 80% in stocks and 20% in bonds. As a retiree, the investor wants a more conservative portfolio in case the stock market drops and given the retiree’s plans to withdraw some savings each year to cover living expenses. As a result, the investor chooses a new asset allocation of 70% in bonds and 20% in stocks, with 10% of the account in cash.

Types of Asset Classes

Each asset class offers different levels of risk and reward. Here are the three most common asset classes, ranked from least risky to most risky:

Cash: This is the least risky, but the return is negative once inflation costs are taken into account. This category includes money market funds and certificates of deposit.

Bonds: There are many types of bonds, but they are all fixed-income investments. The safest among them are U.S. Treasury bonds. They are 100% guaranteed by the federal government and offer a slightly higher return than cash. State and municipal bonds come with greater risk and reward. Corporate bonds offer higher returns but a greater risk of default, particularly high-yield bonds. You should also consider international bonds, including those in emerging markets.

Stocks: These are riskier than bonds because you can lose 100% of your investment. Over time, stocks provide the highest returns and typically outperform inflation. Within stocks, there are three subcategories based on the size of the company: small-cap, mid-cap, and large-cap stocks. Like bonds, you should also have some international stocks and stocks in emerging markets in addition to domestic stocks.

There are many other categories you should also consider: real estate, commodities, currencies, and cryptocurrencies. Digital assets are a highly volatile asset class that includes cryptocurrencies, crypto tokens, and crypto commodities. These digital assets operate differently from one another and should be evaluated with a broader perspective on asset allocation and considering the individual’s risk profile. Some financial planners say you should only allocate what you can afford to lose sleep over if it drops to zero.

How Does Asset Allocation Work?

Let’s say Sarah, an investor with $10,000, decides to split her money among three assets: stocks, bonds, and cash. First, she decides to put 60% of her money in stocks. She also decides to split the amount between large-cap stocks like Coca-Cola and Reebok and small companies that most people have never heard of, known as “small caps.”

Sarah puts $4,000 in index funds that track large-cap companies and $2,000 in index funds that track small-cap companies. She allocates $3,500 or 35% to fixed-income investments, splitting it evenly between U.S. Treasury bonds and municipal bonds (city or state). Finally, she keeps $500 in cash in a money market account.

When the inevitable market downturn occurs, Sarah will be better protected against a significant loss due to her investments in bonds, which are not as volatile as stocks. However, when the stock market rallies, the large portion of her portfolio invested in stocks is likely to perform well.

Allocation

Your Assets and Goals

How much should you allocate to each asset class? It depends on three factors: your investment goals, time horizon, and risk tolerance. Your goals, time horizon, and risk tolerance will determine the model you should use. If you can tolerate high risk for the potential of high returns, you are likely to put more in stocks and mutual funds. Those with a low risk tolerance will prefer bonds. Those who have a low risk tolerance or those who will need their money in the next year should keep more cash.

Asset Allocation vs. Diversification

While asset allocation is a crucial part of creating a diversified portfolio, it is not the same concept as diversification. You can spread your money across several types of assets without properly diversifying those investments. For example, if the stocks in your portfolio are securities from a few large companies, you may not necessarily be diversified adequately for better growth. Diversification in your portfolio means covering different levels of risk and return with your various investments. Allocation is one way to achieve this, but you should always take an additional step to diversify within each asset class.

Why is Proper Allocation Important?

Allocating assets based on an individual investment strategy is what every good investor considers. Even wealthy individuals and institutional investors lose money on some bets, but because they are properly hedged, it ensures that they do not face significant harm from one bad investment. Balancing stocks, fixed income, and cash instruments is also important, as it is a strategy that allows for post-economic movements outside the investor’s time horizon. Proper allocation allows for currency fluctuations and larger geopolitical movements, providing investors with a safety net against significant downturns.

Source: https://www.thebalancemoney.com/what-is-asset-allocation-453765