What Is Asset Allocation?

Asset allocation is the overall mix of investment types, such as stocks, bonds, and mutual funds, in a portfolio. This mix is essential for successful long-term investing because it influences the portfolio’s performance more than the type of investments selected.

What Is Asset Allocation?

Asset allocation is the percentage of a portfolio’s investments in stocks, bonds, and cash. For instance, more conservative investors might have many bonds, whereas more aggressive investors might have many stocks.

Mixing targeted assets diversifies risk and return characteristics, helping meet an investor’s goals and situation. These decisions should be periodically reviewed and modified to ensure alignment with the investor’s changing objectives and needs.

Why Is Asset Allocation Important?

Asset allocation typically drives a portfolio’s long-term performance. For instance, a portfolio that holds 70% in stocks and 30% in bonds is likely to perform very differently from a portfolio with 30% in stocks and 70% in bonds.

Benefits of Combining Asset Allocation and Diversification

Asset allocation is typically paired with diversification, the mix of investments within each asset classification. Holding diverse investments within each classification reduces the risk that a stock or bond will significantly undermine the portfolio’s performance. If one asset underperforms, others might perform better, balancing out the returns.

The benefits of combining asset allocation and diversification include:

Smoother Portfolio Performance

Stocks and bonds have historically provided positive returns over long periods. However, the assets’ values can decrease, and they tend to lead and lag at different times. Holding money in each category increases the odds that a temporary poor performance in one group will be offset by strong performance in another, cushioning the bumps on the total portfolio.

Increased Likelihood of Attaining Investment Goals

Allocating funds among asset types and diversifying across a variety of investments reduces the odds of an extreme outcome, such as substantial loss, over long periods. Proper asset allocation helps ensure an investor does not take on a level of risk that would jeopardize their goals.

Support Maintaining an Investment Plan

Spreading risk and reducing portfolio losses make it easier to stick with an investment plan. For instance, investors are less likely to sell stocks when the market is down, potentially losing money.

Tips to Select Your Asset Allocation

Consider the following variables when choosing your asset allocation:

• Time horizon

• Needs

• Preferences

• Financial picture

• Balancing risks and potential returns

Emphasize these three factors when deciding on your asset allocation:

1.  Your Goal and Time Horizon

Develop distinct asset allocations for each goal, such as retirement or your child’s college fund. The longer your time horizon, the more risk you might take to receive potentially higher returns. Your investments have more time to recover from any short-term declines in value.

 

2.  How Much Risk Your Financial Situation Can Support

Determine how well you could handle any temporary declines in your portfolio’s value. For instance, if you have a strong emergency fund, adequate insurance coverage, and a regular paycheck from a reasonably safe job, you might have a high capacity to take on risk.

 

3.  Your Comfort Level with Market Ups and Downs

Successful investing requires keeping your assets despite changes. Determining your risk tolerance and not selling your investments when the market declines help capture potential long-term gains. 

If these three factors suggest you should take on significant risk and pursue potentially higher returns, your asset allocation likely should include more stocks and fewer bonds. However, if these factors indicate you should take on less risk and pursue potentially lower returns, your asset allocation likely should include more bonds and fewer stocks.

Asset Allocation Models and Strategies

Asset allocation models and strategies are available online to help determine which mix might be right for you. You should periodically revisit and update your asset allocation, especially when your goal or financial situation changes.

Gradually reduce your allocation for a goal as you near it. For instance, consider gradually reducing your stock investments and increasing your bond investments as you near retirement.

*This information is for educational purposes only.

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