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What Is Asset Allocation?

Asset allocation is a vital strategy to protect your portfolio from large losses. It refers to investment diversification across a variety of assets.

There are a variety of investments that are considered an “asset.” They can be anything from cash, stocks, bonds, and even your home. All assets play an important role within your portfolio. With the right mix, you will be able to better control the risk your portfolio bears.

Why Is Asset Allocation Important?

One of the most important decisions you can make for your portfolio is proper asset allocation, according to most financial advisors. As the old saying goes, “don’t put all your eggs in one basket.” In this case, the eggs we are referring to is the money you are going to invest, and the basket represents the asset you choose to invest in.

Utilizing asset allocation can help you ensure that all your “eggs” are spread out across numerous “baskets.” But asset allocation is not a one-size-fits-all strategy. It is personal based on what is best for you at your current stage in life and with your future goals in mind.

Typically each asset has a recommended holding period. Money market accounts and cash are ideal for objectives a year or so away, where stocks are recommended for at least five years or longer. Bonds can fall somewhere between. Depending on your age, you can determine what portion of your capital to allocate to the different investment vehicles.

What Is the Primary Goal of Asset Allocation?

The goal of asset allocation is to balance the risk and reward of your portfolio. By dividing your investments among the different asset classes, you can reach your goals while also mitigating your risk.

When you make investment decisions, you are typically influenced by many factors. Your investment goals, risk tolerance, and timeline will all help determine the best course of action for how you allocate your assets.

Five Elements of Asset Allocation

Assets are categorized into various asset classes. Within each asset class is a group of investment vehicles that are all similar. That means different types of asset classes have multiple investments grouped within them. The three main asset classes are equities, fixed-income, and cash and equivalents. Beyond these three main classes are alternative assets that include real estate and commodities.

Equity

When you own stock in a public company, you become a shareholder and have equity. The terms “equity”, “stock”, and “shares” can all be used interchangeably for this investment vehicle. The stock market provides investors with exchanges to buy and sell shares of stock in multiple public companies. Your investment grows through the price of share increase or through dividends.

Fixed Income

Fixed income investments include bonds and other debt securities that pay interest until the maturity date. Upon maturity, you will be repaid the principal amount that you invested in the security. These investments have less risk than stocks.

Cash & Cash Equivalents

The most liquid of all asset classes, cash and cash equivalents can be easily accessed at any point in time. Certificates of deposit and money market funds fall into this category. This is the least risky asset class, but typically provides a lower return.

Real Estate

Investments in real estate and/or real estate investment trusts (REITs) are considered an alternative asset. However, owning real estate and investing in a REIT carry different risks.

Real estate can make money through monthly generated income and/or on the price appreciate. Real estate investment trusts are on the stock market and require much less work than physically owning real estate.

Commodities

Because there are so many types of commodities, they all come with varying levels of risk. Investors who are looking to invest in an asset class outside of the stock market find appeal with commodities including gold, silver, energy resources, wheat, and many others. They are raw materials that are used or consumed to build other products.

Rule of Thumb: Asset Allocation by Age

If you are trying to determine just how much you should invest in the stock market, there is a common rule of thumb – the Rule of 100. Most financial advisors suggest subtracting your current age from 100 to determine what percentage you should invest in stock.

For example, if you are 30 years old, you would want to invest 70% in stock (100-30=70), but as you age, you will want to adjust your asset allocation. When you turn 50, you would want to have only 50% invested in stocks (100-50=50).

This is not a hard-fast rule, and depending upon your personal goals, you might have a portfolio that requires more risk to retire early.

How Do I Start Asset Allocation?

When you are ready to ensure your portfolio is divided among numerous asset classes, you can either work with your financial advisor or review your portfolio on your own.

Know Your Risk Tolerance

Risk tolerance is one of the most important factors when considering how to tackle your portfolio’s asset allocation. If you have a high-risk tolerance, you will be less likely to lose sleep over the thought of losing money. Alternatively, if you have low-risk tolerance you will want to approach your asset allocation strategy with a more conservative approach so you can sleep comfortably at night.

Identify Your Financial Plan

Your financial plan provides a full picture of your current finances, future goals, and current investment strategies to help you maximize your wealth. A good financial plan considers your cash flow, savings, investments, debt, and other elements of your financial life. Ensure your wealth is protected by allocating your assets when you revisit your financial plan.

Choose a Mix of Assets

To achieve optimal asset allocation you will want to have a mix of stocks, bonds, and other asset classes. You will need to determine what mix is right for your personal needs based on your time horizon and risk tolerance. You can always use the Rule of 100 to help guide you, or your financial advisor can provide you with guidance to build a portfolio with asset allocation in mind.

Ideal Portfolio Will Change Over Time

Over the course of your life you will have different goals and investment strategies that can help you get there. Your portfolio’s asset allocation should continue to be adjusted as you reach different milestones and stages in life. Your financial advisor can help you determine when to rebalance your portfolio’s asset allocation and help protect and maximize your wealth for your future.