What Is Asset Allocation?

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DEFINITION

Asset allocation involves diversifying your investments among a variety of different types of assets. It helps protect you from large losses in your portfolio.

Definition and Example of Asset Allocation

Asset allocation involves spreaading your money among different assets, such as equities, fixed-income, and cash equivalents. Each of these categories responds differently to varying trends in the market, so having a blend of them in your portfolio will help you minimize losses in a market downturn.

In general, the younger you are, the higher the percentage of equities you should own. That is because you have a longer investment period in which to make up losses if they occur, and the stock market has generally trended upward over time. More seasoned investors might have a higher percentage of fixed income holdings and might be more reliant on regular income than on big stock gains.

For example, suppose an investor will soon enter retirement and currently has an asset allocation of 80% equities and 20% bonds. As a retiree, the investor wants a more conservative portfolio in case the equity market declines and since the retiree plans to withdraw a portion of the savings each year for living expenses. As a result, the investor opts for a new asset allocation of 70% bonds and 20% equities, along with 10% of the account in cash.

Asset allocation is a key component of any investment strategy. Your portfolio should be diversified, and how your assets are allocated partially determines how diversified you are.

Types of Asset Classes

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

  1. Cash: This is the least risky, but the return is negative once you've taken out the cost of inflation. Money market funds and certificates of deposit are in this category.
  2. Bonds: There many types of bonds, but they are all fixed-income investments. The safest 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 offer slightly greater risk and reward. Corporate bonds offer a greater return but a higher risk of default. That's especially true for junk bonds. You should also look at international bonds, including those in emerging markets. 
  3. Stocks: These are riskier than bonds, because you can lose 100% of your investment. Over time, stocks offer the greatest return and will generally outpace inflation. Within stocks, there are three sub-categories based on how valuable a corporation is: small-cap, mid-cap, and large-cap. Like bonds, you should have some international and emerging market stocks as well as domestic ones.

There are many other classes that you should also consider:

  • Real estate: This includes investment property such as a rental unit, investments in a real estate investment trust (REIT), or a pooled real estate fund of one type or another. Opinions differ among experts as to whether or not to include the home you live in (if you own it) as part of this allocation.
  • Derivatives: These offer the highest risk and returns. Keep in mind that you can lose more than your investment. 
  • Commodities: Risk can vary, because there are so many types. However, most investors should own shares of an oil-related mutual fund, as it should rise over the long term as supplies dwindle. It's generally recommended that you have no more than 10% allocated to gold.
  • Currencies: As the dollar declines, it's good to have assets denominated in foreign currencies such as the euro. When the dollar is weak, then the euro might be strong. The two mixed economies are the same size, so they compete with each other in the forex market.
  • Cryptoassets: This is generally a highly volatile asset class that can include cryptocurrencies, crypto tokens, and crypto commodities. These digital assets function differently from each other and need to be assessed with a broader asset-allocation view and with an individual's risk profile in mind. Some financial planners state that you should only allocate what you wouldn't lose sleep over if it were to drop to zero.

How Does Asset Allocation Work?

Consider Sarah, an investor who has $10,000. She decides to split her money into a three-way combination of equities, fixed-income, and cash. First, she decides to put 60% of her money into equities. She further decides to split the amount among the categories of large companies, such as Coca-Cola and Reebok, and small companies that most people have never heard of, called "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 puts $3,500, or 35%, in fixed-income investments, splitting it evenly between U.S. Treasury bills and municipal (city or state) bonds. Finally, she keeps $500 in cash, which she holds in a money market account.

When the market takes an inevitable downturn, Sarah will be better protected against a large loss because of her bond investments, which are not as volatile as stocks. But when the stock market takes off, the large portion of her portfolio that's invested in stocks will be more likely to perform well.

Asset Allocation and Your Goals

How much should you allocate to each asset? It depends on three factors:

  1. Your investment goals: Are you planning for retirement, retired already, or saving for a down payment on a house?
  2. Time horizon: How long will it be before you need the money?
  3. Risk tolerance: Can you stand to watch your investments plummet at times, knowing that, in the long run, you'll probably receive a higher return? 

Your goals, time horizon, and risk tolerance will determine the model you should use. If you can tolerate high risk to obtain a high return, you'll likely put more into stocks and mutual funds. Those with a low risk tolerance will favor bonds. Those with zero risk tolerance, or those who will need their money within the next year, should retain more cash. 

Asset Allocation vs. Diversification

Although asset allocation is a critical part of creating a diverse portfolio, it's not quite the same concept as diversification. You can allocate your money across several types of assets without properly diversifying those investments. For example, if the stocks in your portfolio are all securities in just a few large-cap companies, you're not necessarily diversified for better growth.

Diversifying your portfolio means covering a lot of different risk and return levels with your various investments. Allocation is one way to do that, but you should always go a step further to diversify within each asset class.

Why Proper Allocation Is Important

Allocating assets based on an individual investment strategy is what almost every investor would consider good practice. Even billionaires and institutional investors lose money on certain bets, but since they are properly hedged, it ensures that they will not be significantly harmed by a single bad investment.

A balance among equities, fixed income, and cash instruments are also important, because it is a strategy that allows for macroeconomic movements beyond an investor's horizon. Allocating properly allows for fluctuations in currencies and larger geopolitical moves, giving the investor a safety net against large-scale declines.

Key Takeaways

  • Asset allocation is the process of spreading your investments over various types of assets to guard against changes in the market.
  • Investors typically allocate some of their investments toward stocks, bonds, and cash equivalents, but there are other asset types to consider as well, including real estate, commodities, and derivatives.
  • The best mix for you depends on your investment goals, time horizon, and risk tolerance.

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