What Is Asset Allocation?
Asset allocation is the practice of dividing an investment portfolio into different types – or classes – of assets, such as stocks, bonds, and cash. These asset allocations change over time depending on a variety of different factors, including the investor’s time horizon and risk tolerance.
There are several different asset classes:
Stocks/Equities –
Stocks, or equities, have historically offered the highest risk and highest returns. But, not all stocks are the same. Large-cap stocks are less risky and small-cap stocks have more risk. Investors willing to put up with the volatility of stocks have realized the best positive returns over time.
Bonds & Fixed Income –
Bonds have historically had less volatility than stocks, but the trade-off is that they offer more modest returns. But, there are some types of bonds that are riskier, such as junk bonds and high-yield bonds. Investors with a short time horizon often keep their investments in bonds since they offer stability and income.
Cash & Cash Equivalents –
Cash and equivalents are the least risky asset class since there’s very little risk of losing capital. In addition to cash, these investments might include certificates of deposit, Treasury bonds, or other cash-like securities.
Selecting the right asset allocation depends on several factors, including:
Time Horizon –
The number of months or years until your financial goal is the primary factor driving asset allocation. Investors saving up for retirement often invest in riskier assets since they have a long time horizon, while a parent saving up for a teenager’s college education may stick to less risky investments since they have a shorter time horizon.
Risk Tolerance –
The second major factor influencing asset allocation is an investor’s risk tolerance. In other words, their ability and willingness to lose some or all of their original investment in exchange for greater returns. Aggressive investors may be willing to take on higher risk to get better returns, while conservative investors may stick with low-risk investments aimed more at capital preservation.
The Importance of Asset Allocation
Asset allocation helps investors reduce risk through diversification. Historically, the returns of stocks, bonds, and cash haven’t moved in unison. Market conditions that lead to one asset class outperforming during a given timeframe might cause another to underperform. The result is less volatility for investors on a portfolio level since these movements offset each other.
In addition to diversification, asset allocation is essential to ensure that you reach your financial goals. An investor that isn’t taking on enough risk might not generate high enough returns to reach their goal, while an investor that’s taking on excessive risk may not have enough money when they need to access it. Selecting the right asset allocation helps avoid these issues by ensuring that a portfolio is ideally positioned to reach a goal.
Asset allocation accounts for a whopping 88 percent of volatility and returns, according to Vanguard, which means that your experience will be very consistent with any other diversified investor with the same asset allocation regardless of the specific investments you choose. In other words, asset allocation matters a lot more than stock picking when it comes to reaching your financial goals!
Comments