What Is Asset Allocation?

How this one strategy can help boost your investments

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Asset allocation refers to diversifying your investments among a combination of equities, fixed-income and cash equivalents.

I know -- that probably sounded like jargon. Stay with me.

An "asset" can be anything from your home to your right to collect royalties on a book that you wrote. But when people describe asset allocation, they're usually talking about money -- cash -- that you put in the stock market.

You use this money in three main ways: You buy companies. You give loans. Or you keep it in cash.

Buying Companies

When you buy shares of stock, you're buying "equities." When you buy a share of Apple stock, you become a part-owner of the company. You have "equity" in Apple.

If you don't want to buy stock directly, you can buy a fund that holds a LOT of different stocks. Mutual funds and index funds, for example, are collections of lots of different types of stocks, bundled together in one convenient basket.

Giving Loans

When you buy a bond, you're giving out a loan to whatever group "issued" (asked for) that bond. If you buy a corporate bond, for example, you're giving that company a loan. The company has to pay you interest on that loan. It has a "payment plan" on a fixed timeline. For example, it might pay you interest once a month, or once every three months.

That's why this is called a "fixed-income" investment: you get income on a fixed schedule.

Keep it in Cash

You can also keep your money in regular cash, which is easy to understand. Or you could put it into a Certificate of Deposit, which is an example of a cash equivalent.

So What is Asset Allocation?

Asset allocation means that you spread your money between a combination of equities, fixed-income and cash equivalents. Doesn't that make more sense now?

Asset allocation is a key component to any investment strategy. Your portfolio should be diversified, and how your assets are allocated partially determines how diversified you are. Your asset allocation will likely change as you age to accommodate changes in appetite for risk. 

Example of Asset Allocation:

Sarah has $10,000. She decides to split her money into a combination of equities, fixed-income, and cash.

First, she decides to put 60 percent of her money into equities. She further decides to split this between large companies like Coca-Cola and Reebok, and small companies that most people have never heard of.

She buys $4,000 in index funds that track large-cap companies and $2,000 in index funds that track small-cap companies. That's a total of $6,000, or 60 percent of her money, in equities.

She puts $3,500, or 35 percent, in fixed-income investments. She splits this 50/50 between U.S. Treasury bills and municipal (city) bonds.

Finally, she keeps $500 in cash, which she holds in a money market account.

As you can tell, Sarah is fairly diversified in her holdings. She isn't investing strictly in stocks, bonds, or cash. Rather, she has a mix of the three in her portfolio, which will serve her well when the market becomes volatile.