Asset allocation definition
Asset allocation is dividing an investment portfolio across different asset classes, such as stocks, bonds and cash, according to the US Securities and Exchange Commission’s (SEC) definition.
The best asset allocation for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
What is the primary goal of asset allocation?
The primary goal of asset allocation is to help you reach your investment goals at a risk level that is in line with your risk tolerance.
If your portfolio includes asset classes with returns that move in different directions under different market conditions, you’ll reduce the risk of suffering significant losses. Market developments that cause one asset class to do well often lead to poor performance in another asset class. In such cases, the ability to rebalance your portfolio by selling some of your best-performing assets to buy some slumping ones can greatly improve your overall performance in the long run.
Asset allocation can also help reach more balanced investment returns. If returns fall in one asset class, you have a chance to offset some of your losses in another asset class, thus reducing fluctuations in your returns.
How to determine your ideal asset allocation?
First clarify what your time horizon is, taking into consideration your age, annual income, and the financial goal you want to achieve with investing. This can be paying university tuition, buying a new home or preparing for retirement.
After this, gauge your risk tolerance. How much money are you able and willing to risk for better returns? Younger people, for example, might prefer riskier assets when saving for retirement. This is because there might be declines in asset value in the short run, but returns could increase significantly in the long run. On the other hand, people close to retirement age usually prefer low-risk assets like bonds, that can ensure that accumulated savings don't lose value and they can access their savings during retirement.
Now you are ready to make your investment choices. Pick asset classes and select your assets within each category.
A word of caution
Be careful with simplistic rules of thumb for asset allocation!
Have you heard about the “rule of 110”? Take your age and subtract it from 110 to learn what percentage of your funds should be invested in equities. The rest should be in fixed-income or cash, depending on your risk tolerance. Going by this rule, if you're let's say, 30 years old, you should put 80% of your money in stocks.
It would be great if asset allocation would be as simple as that, but it isn’t. This rule, for instance, takes into consideration only your age, while completely ignoring your risk tolerance and financial goals.
What else do you need to know about assets and asset classes?
If you'd like to broaden your knowledge, check out the following articles: