The concept of asset allocation was one of the first concepts I studied on my road to fiscal fitness. Asset allocation is the practice of dividing an investment portfolio among different asset categories. This concept can support another well know investing concept, diversification, spreading your money among various investments in the hope that if one investment loses money, the other investments will make up for those losses. People often get these two concepts mixed up or believe they mean the same thing. Many investors use asset allocation as a way to diversify their investments between the asset categories. However, some investors purposely choose an investment allocation that is not diversified.
Asset Allocation and Diversification
A young investor might go 100% in stocks, 0% in cash and 0% in bonds. This allocation could be viewed as a proper asset allocation because they are willing to assume a high level of risk and have a long time to reach their goal. Therefore, choosing an asset allocation model does not necessarily diversify a portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments. To be well diversified, investments should be spread between and within the different asset categories.
The most common asset categories are cash, bonds, and stocks. Cash and cash equivalents (e.g. savings deposits, certificates of deposit [CD], treasury bills, money market funds, and money market accounts) are the safest investments as the federal government guarantees many of the investments in this category. However, they generally offer the lowest return of the three major asset categories and a concern for SavvyInvestors is that inflation will outpace the rate of return and erode the cash asset value over time.
In the middle of the spectrum you have bonds. They generally offer better returns than cash and cash equivalents, yet lower returns than stocks. For many investors, holding bonds is an attractive alternative to leaving the investment portfolio at greater risk if too heavily weighted toward stocks. Investopedia provides a good basic tutorial on the different types of bonds.
On the other end of the spectrum from cash is stocks. Stocks, also referred to as equities, represent a share of a company held by an individual or a group. This asset category has historically had the greatest volatility, greatest risk, and highest returns among the three major asset categories. Their appeal is that they offer investors the greatest potential for growth. Mutual funds, made up of a collection of stocks, bonds, and other securities would also be grouped into this asset category.
SavvyInvestors understand that the reward for taking on more risk is that there is a potential for a greater return on investments. Generally speaking, the longer the time horizon, the more likely investors will make more money by thoughtfully investing in asset categories (e.g. stocks and bonds) with greater risk, vice limiting investments to assets with less risk – and less return – like cash and cash equivalents.
Remember, to be well diversified, investments should be spread between and within the different asset categories. The mix of cash, bonds, and stocks that you hold in your portfolio at any given time is very personal and will change over time. The allocation of your assets is not a case of doing it once and being done; it is not a static practice.
A common practice among investors is to increase their cash and bond holdings, relative to their stock holdings (providing greater protection to their nest-egg), as they approach their investment goal, retirement in many cases, and prepare to start the withdrawal process.
Ultimately however, the asset allocation that works best for you at any given point in your life will depend largely on numerous factors such as your tolerance for volatility and risk, your time horizon, and your goals.