Asset allocation refers to diversifying your investments among a variety of different types of assets. It can help protect you from large losses in your portfolio.
An "asset" can be anything from your home to your right to collect royalties on a book that you wrote. When people describe asset allocation, however, they are usually talking about cash invested directly in the capital markets. Here's a look at the key role asset allocation plays in your investing strategy.
What Is Asset Allocation?
Asset allocation means that you spread your money among different assets, such as equities, fixed-income, and cash equivalents. Each of these responds differently to different 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 a 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.
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 least risky to the riskiest:
- 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.
- 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 returns but a higher risk of default. That's especially true for junk bonds. You should also look at international bonds, including emerging markets, as well as domestic ones.
- 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 large the capitalization is: small cap, mid cap, and large cap. Like bonds, you should have some international and emerging market stocks as well as domestic.
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% of allocation in gold.
- Currencies: As the dollar declines over the long term, it's good to have assets denominated in foreign currencies such as the euro. When the dollar is weak, then the euro is strong. The two mixed economies are the same size, so they compete with each other in the forex market.
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 between 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 buys $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 perform well.
Asset Allocation and Your Goals
How much should you allocate to each asset? It depends on three factors:
- Your investment goals: Are you planning for retirement, retired already, or saving for a downpayment on a house?
- Time horizon: How long will it be before you need the money?
- Risk tolerance: Can you stand to watch your investments plummet at times knowing that, in the long run, you'll 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 put more into stocks and mutual funds. Those with a low-risk tolerance will favor bonds. Those with zero risk tolerance, or who need their money within the next year, should have 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 have your money allocated 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 diversified for a better growth.
Diversifying your portfolio means covering a lot of different risk and return levels with your various investments. Allocation is one way of doing 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 is 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.
- 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.