What Is Asset Allocation?

Asset Allocation Explained

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Asset allocation refers to diversifying your investments among a combination of equities, fixed-income, and cash equivalents. 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, they are usually talking about cash invested directly in the capital markets.

What Is Asset Allocation?

Asset allocation means that you spread your money between a combination of equities, fixed-income, and cash equivalents. General practice is that the younger you are, the higher percentage of equities you own. This is because you have a longer investment period in which to make up losses if they occur. The stock market has always trended up over time, so if you are young time is an asset as well. More seasoned investors might have a higher percentage of fixed income holdings and are 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.

Your asset allocation will likely change as you age to accommodate changes in appetite for risk. 

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:

  1. Cash: 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 you also have a bigger risk that they'll default. That's especially true for junk bonds. You should also look at international bonds, including emerging markets, as well as domestic. 
  3. Stocks: These are riskier than bonds because you can lose 100% of your investment. Over time, stocks offer the greatest return and will 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 the equity in your home, which most financial advisers don't count because you live in it. But the value could deteriorate. You would lose all your investment if you foreclose. It can also skyrocket, forcing you to have too much in this one asset class.
  • Derivatives: These offer the highest risk and returns. Keep in mind 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. It should rise over the long-term as supplies dwindle. You should have no more than 10 percent 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. It protects you against declines in the dollar. For example, 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?

Sarah, an investor, 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 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, called small-caps.

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%, of her money in equities. She puts $3,500, or 35%, in fixed-income investments. She splits this evenly between U.S. Treasury bills and municipal (city) bonds. Finally, she keeps $500 in cash, which she holds in a money market account.

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 downpayment 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 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 stick with bonds. Those with zero risk tolerance, or who need their money within the next year, should have more cash. 

If you have a long time horizon, then you can afford to put more into your house and watch it grow. If you have a short time horizon, then put more into bonds or even cash.

Why Proper Allocation Is Important

Many investors would say that Sarah is well 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.

This does not mean that she will necessarily profit during market downturns, but it can mean that she is protected against total loss through a process called "hedging," which postulates that when one sector goes down, the opposing one tends to rise. Many of the world's largest funds place hedge bets against their larger holdings, just in case their research was wrong. Through hedging, an investor can limit downside potential.

Allocating assets based on your individual investment strategy is what almost every investor would consider good practice. Even billionaire institutional investors lose money on certain bets. But since they are properly hedged, it ensures they will not go down on a single bad investment.

A balance between 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 changes.