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How Asset Allocation Works
As the name implies, asset allocation is the process of dividing a portfolio among different asset classes such as stocks, bonds and cash. Usually, you assign a specific percentage (or percentage range) to a particular class based on your personal preferences. But there is no definitive percentage that is universally accepted -
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Be aware that asset allocation is not
a guarantee of future success.
As with any investment strategy,
there is an element of risk. |
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A Personal Determination
The Securities and Exchange Commission explains that the asset allocation that works best for you at any given point in your life depends largely on two factors:
Your Time Horizon or the expected number of months, years, or decades you'll be investing to achieve a particular financial goal. An investor with more time may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable market ups and downs.
Risk Tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. Aggressive investors, with a high-risk tolerance, are more likely to risk losing money in order to get better results. Conservative investors, with a low-risk tolerance, tend to favor assets that preserve their original investments. | everyone's situation is different.
In fact, the asset allocation percentages you use depend on a number of factors, including your personal and financial circumstances, your investment "time horizon" and your ability to tolerate risk.
Generally, the longer you have to invest, the more you might be willing to risk in return for a potentially greater reward. For instance, a young professional may be inclined to tilt his or her portfolio to a heavier concentration of stock holdings than a retiree living on a fixed income.
Three Major Asset Classes
The three major classes used in asset allocation, especially for novice investors, are stocks, bonds and cash.
1. Stocks - Historically, this class has the greatest potential for reward, coupled with the highest risk. You might hit a home run with stocks or strike out completely. The risks can obviously be reduced somewhat by investing in stocks through mutual funds.
Within this category are stocks that are large-cap, small-cap, growth, value, international, etc.
2. Bonds - Most bonds are generally less volatile than stocks, but offer more modest returns. As a result, an investor approaching a financial goal might increase bond holdings relative to stock holdings. However, certain types of bonds, known as high-yield or "junk" bonds, carry a greater risk than other bonds.
Bond mutual funds are an alternative to buying specific bonds.
3. Cash - Cash and "cash-equivalents" such as Certificates of Deposit (CDs), Treasury securities, money market funds and savings deposits are generally the safest type of investments. But these typically offer the lowest return of the three major asset classes
Other classes - In addition, more sophisticated investors might allocate a portion of their portfolios to other classes, including real estate, precious metals and private equity. Naturally, specific risks are associated with these investments, so be sure you understand all the potential ramifications.
Look Back and Ahead
As you examine your investment statements, you may find that your current asset allocation no longer reflects your personal preferences. For example, let's say that you designated stock holdings to comprise 50 percent of your portfolio. However, due to recent market fluctuations, that figure is now either 15 to 20 percent higher or lower than the 50 percent level. Therefore, you may choose to shift more or less investment dollars into stock holdings to meet your objectives.
Note that this is just a hypothetical example and not indicative of any particular investor. The actual percentages and types of investments you choose for your portfolio will vary.
Why Asset Allocation Matters?
Having the right mix of assets helps you reach your financial goals, which might involve retirement or college saving. It can also help protect you against significant losses. The Securities and Exchange Commission notes:
"Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category."
This is a basic rundown of asset allocation. The optimal approach is to consult with your investment adviser to analyze your holdings. Then, if needed, adjust your portfolio accordingly. This will restore the proper investment balance for 2008.
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