Investing 101: What Is Asset Allocation?
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Date: August 4, 2016
Asset allocation sounds like a highbrow finance term, but it's a pretty simple concept in reality. Most people want to earn the highest possible return when they invest their hard-earned money, while taking the least amount of risk. Asset allocation tries to achieve this balance by using statistical models of historical risk and return. The "correct" formula can vary from investor to investor.
How Does Asset Allocation Work?
Asset allocation spreads your money over different types of investments to help limit the volatility in your account. Most investors would love an account that goes straight up in value, but no investor wants one that goes straight down. Asset allocation addresses this problem by scattering assets across investments that do not move in correlation — in other words, a good asset allocation owns some investments that move up while others go down. Over time, all the investments in a good allocation should see an appreciation in value, but owning investments that don't all move up or down at the same time helps minimize the risk along the way.
Sample Asset Allocations
A typical asset allocation carries a mix of stocks, bonds and cash, often divided into subcategories. For example, the stock portion of your asset allocation may include large U.S. companies, small European companies and high-growth stocks based in India or Indonesia. Your bond allocation may include interest-bearing investments that pay off over one year, five years or 20 years.
If you're an investor with a high appetite for risk, your asset allocation might include more stocks than bonds or cash. On the other end of the spectrum, a conservative investor set to retire in five years might own only a handful of stocks, with the bulk of his asset allocation represented by cash and short-term bonds.
The Importance of Rebalancing in Asset Allocation
Even the best-designed asset allocation should be monitored and rebalanced regularly. Rebalancing is necessary when the success — or failure — of a particular asset group alters the overall allocation. For example, if you have a 60 percent allocation to stocks and the stock market has a huge rally, your stock weight might rise to 75 percent. Because your original allocation devised the most appropriate balance of risk and return for you, that 75 percent allocation should be trimmed back to the original 60 percent.
The investment principle behind re-balancing is simple — you're essentially taking profits from your winners and allocating additional funds to your losers. This way, you protect some of your profits while buying additional assets when they are down.
The Pros and Cons of Asset Allocation
The main benefit of asset allocation is that an investor generally shouldn't experience wild swings in value with assets spread over many different sectors. According to a study published in 1986, as much as 90 percent of a portfolio's variation can be attributed to its asset allocation, rather than the selection of individual investments.
The negative side of asset allocation is that to mute volatility, you often have to mute performance as well. If the stock market goes higher, a balanced portfolio can work against you because your return will fall short of the stock market. To achieve a higher return, you will also have to take on more risk, something an asset allocation is designed to protect against.