What does asset allocation mean?

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When the market is volatile, you might be hesitant to put your money into an investment portfolio. What even is a portfolio? It sounds like something complicated and slightly overwhelming. There are lots of things to understand and a lot of terms — What are assets? What is asset allocation? How do you diversify?

Asset allocation is the base principle of building an investment portfolio, and understanding how it works is key to getting started towards your financial goals. Investing doesn’t have to be complicated — unless you want it to be.

Asset allocation is simply how your investment portfolio is divided up into different assets — ie. how your money is allocated across asset classes and within each category.

There are lots of different kinds of assets: stocks, bonds, cash, real estate, commodities and even private equity or hedge funds. When you invest your money, you typically put it into different kinds of assets.

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Determining what kind of asset allocation makes the most sense for you depends on your personal goals, time horizon and risk tolerance.

Asset allocation also refers to how money is allocated within the asset class. That means you might decide to put a portion of your investments into stocks (an asset class), but you also have to decide which kinds of stocks you’ll invest in depending on what you’re looking for in return, risk and time frame.

What is asset allocation? It’s just a fancy term for how you decide to invest your money across different kinds of assets or investments.

Related: Effective investing as a couple

What is a good asset allocation strategy for most investors?

In his book All About Asset Allocation, Rick Ferri says, “Your investment policy and portfolio asset allocation will be unique. It will be based on your situation, your needs today and in the future and your ability to stay the course during adverse market conditions. As your needs change, your allocation will also need adjustment. Monitoring and adjusting is an important part of the process.” 

His point is there is no one perfect asset allocation. Selecting the best asset allocation to meet your financial goals depends on a number of factors, most importantly your timeframe and your risk tolerance.

For example, if you’re very far away from retirement, then you may be able to handle more risk in your retirement portfolio. But if you’re investing for your teenage kids’ college education, then that’s a shorter time frame and you probably shouldn’t take as many risks.

Your risk tolerance will also affect how you react to ups and downs in the market. Multiple studies have correlated the frequency with which you check your portfolio to losses over time — the more you stress over it, the more likely you are to pull your money out when you should just wait and stick with it.

So if you’re going to be someone who worries about every little blip in your investment portfolio, then you might need less risky investments. No investment is without risk, but you can spread the risk out across different assets and asset classes.

And, in general, higher-risk investments often have higher returns — which is also why you probably want to pick an asset allocation that balances the amount of risk you can handle with the amount of return you’re looking for.

The most common assets you can invest in are:

•   Stocks: Stocks can be volatile, with the market going up and down, but they can also offer a higher return than bonds over the long run, which is generally defined as any period longer than 10 years.
•   Bonds: Bonds, such as treasury or municipal bonds, can be low risk because they’re backed by government entities, but they also offer lower returns. There are higher-yield bonds and corporate bonds, as well, which have slightly higher returns and slightly higher risk, but are typically still lower risk than stocks.
•   Cash or cash equivalents: This includes money in savings accounts or money market accounts, as well as certificates of deposit or treasury bills. Obviously, the returns on these are very low but they’re also very secure. The biggest concern with cash investments is if inflation outpaces the return, then you technically could be losing money (e.g. future purchasing power).

There are other more complicated assets you can invest in, but for most people an asset allocation made up of stocks, bonds and cash is appropriate.

A common rule of thumb is known as The 100 Rule: Subtract your age from 100 and that’s the percentage of your portfolio that should be invested in stocks.

For example, if you’re 25, then the 100 rule would suggest that 75% of your portfolio be in stocks and 25% in safer investments, like bonds, treasury securities, cash or money market accounts.

Target date funds, in fact, are simply funds that more or less follow this style of rule — automatically adjusting the make-up of stocks vs. bonds as you near your target retirement date.

However, there are some caveats to this rule of thumb — people are living longer. Your particular situation might be different, and it really only is an asset allocation suggestion for your retirement investments, not any other financial goals you might have (Some financial advisors have even adjusted it to The 110 or 120 Rule because of increases in life expectancy).

What are other asset allocation strategies?

For investors who want to be more active in their investment decisions or have more complicated financial goals, there are other asset allocation strategies. More complex investments include real estate, commodities (a raw material that can be bought and sold, like gold or coffee), private equity or hedge funds and direct investments in private companies.

There are even more exotic assets, like cryptocurrencies or even things like fine art. All of these can have a place in your investment portfolio depending on your goals, timeframe, risk tolerance, knowledge and willingness to stay informed.

Just because something is more complex does not mean that it will outperform a simpler strategy. If you don’t understand what’s in your portfolio, you’re actually less likely to stick with it during turbulent times in the market.

There are some asset allocation strategies that involve balancing what you want in returns with the different potential assets. For example, you can decide how much return you want over what time period, and then mathematically work out the average returns expected per asset class and weight the asset classes. Of course, that’s no guarantee of a specific return, but it’s one way to create a portfolio.

Another way is to use a long-term strategic asset allocation, like the ones discussed above, but then adjust it tactically for short-term opportunities — ie. because you want to invest in the short-term in a particular stock or company, or put money into a venture capital fund.

The key to active investing like this is knowing when to adjust your strategy. Active investing requires more active involvement — you have to do your research and know about your investments.

What does rebalancing have to do with asset allocation?

The other factor to consider is when to rebalance your portfolio in order to stay in line with your asset allocation goals.

Over time, the different assets in your portfolio have different returns, so the amount you have invested in each changes — one stock might have high enough returns that it grows and makes up a significant portion of your stock investments.

If, for example, you’re aiming for 70% in stocks and 30% in bonds, but your stock investments grow faster until they make up 80% of your portfolio, then it might be time to rebalance.

Rebalancing just means adjusting your investments to return to your desired portfolio make-up and asset allocation.

There are many rebalancing strategies, but you can choose to rebalance at set times — monthly, quarterly or annually — or when an asset changes a certain amount from your desired allocation (for example, if any one asset is more then 5% off your target make-up).

In order to rebalance, you simply sell the investments that are more than their target and buy the ones that have fallen under their target until each is back to the weight you want.

Why is asset allocation important?

The effect of asset allocation has been studied over the years and, while the findings varied, one thing has remained constant — how you allocate your money to different assets is vitally important in determining what kind of returns you see.

Perhaps the pivotal study on the subject found that asset allocation variances accounted for about 90% of variability over a given period from one portfolio to another. When you factor in all the other factors — style within asset classes, asset class timing and fees, asset allocation accounted for 100% of the absolute level of returns.

If you wanted, you could decide to allocate all your money into one asset class, which might make sense for your financial goals depending on what they are, but that’s not a common strategy.

That’s why asset allocation is very closely tied to portfolio diversification. Diversification means spreading your money across a diverse range of assets and diversifying your money within each asset class.

In a general sense, portfolio diversification and asset allocation are important because you probably don’t want to put all your eggs in one basket. You can’t avoid risk entirely, but by diversifying your investments you spread the risk out across multiple assets.

This is easier to understand in the example of the stock market—just because one stock goes down, it doesn’t mean they all do. If you’re invested in different types of stocks, then it’s more likely in the long run your stock investments will go up.

However, it’s more than just diversifying within each asset class — it’s also about diversifying your entire investment portfolio across asset classes and styles. In general, for instance, stocks are considered riskier than bonds — though there are also different kinds of bonds.

It can be difficult to diversify your portfolio on your own — you would have to buy each individual asset, which can be confusing and can come with fees and minimums.

That’s why investors might choose to use mutual funds or ETFs to easily construct a well-diversified asset allocation. A mutual fund or ETF is essentially a pool of money from many investors, which then invests in a number of assets, allowing investors to own a small portion of all of those assets. It can give instant diversification with one click.

You can invest in funds that index the market or funds with target dates (which change the asset allocation automatically over time in order to target a specific retirement date).

There are many different kinds of funds with different asset allocation, and a fund doesn’t guarantee diversification — especially if it’s a fund that invests in just one sector or market. That’s why it’s important to understand what you want out of your portfolio and find an asset allocation to meet your goals — which may require professional help.

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