What is Asset Allocation?
When it comes to investing, you might hear “don’t put all your eggs in one basket.” As a five-year-old during Easter, that would be confusing, but most metaphors would.
Ok, so what do eggs, baskets – and what is asset allocation – have to do with investing?
Think of those eggs as your money and the baskets are the various asset classes you can choose to invest that money in. Deciding how many eggs — or dollars — goes into each basket is called asset allocation.
Asset allocation plays a key role in the amount of risk you take with your investments which affects your investment returns. When you pick an asset allocation, you’re spreading your investable dollars across a variety of investments based on your goals, risk tolerance, and time horizon.
Typical asset classes
Imagine having five piggy banks lined up on your dresser. You need to decide which piggy banks (asset classes) do you want in your portfolio, and how much of your money do you want to put in each?
Asset classes are groups of similar investments. The most typical are stocks, bonds and cash. You can buy stocks, and bonds individually, or in exchange-traded funds, which are baskets of many investments grouped together.
» Learn the basics: What is a stock?
All of these asset classes bring value to your portfolio. How? Stocks offer the greatest potential for long-term growth but also greater risk. Bonds balance out that risk and provide a steady stream of income. Cash is great for emergencies or short-term goals like a down payment on a car because it’s liquid.
Within each class, you can diversify – investing in stocks by industry or market capitalization. Bonds with various maturity dates and so forth. Cash in a high-yield savings account, money market or many other liquid options.
» Learn the basics: What is a bond?
Asset allocation done right
There’s no right or wrong asset allocation. It’s driven by your needs or preferences while also considering your risk, your investment goals, and your time horizon.
Let me show you.
First – when do you need the money and why? If you’re saving for a car in two years, you probably don’t want to put your money in stocks or bonds. Instead, you should favor cash or cash alternatives such as a high-yield savings account or certificate of deposit. You don’t want to be ready to buy that car and find out that the market wiped out your budget.
If you’re saving for retirement, you can calculate your planned retirement age by subtracting your current age. If the latter is 30-some years away, for example, most of your portfolio should be invested in stocks. Why? You have time to ride the market roller coaster without worrying about short-term losses.
As you start prepping to leave the workforce, you’ll shift towards a less risky allocation. That doesn’t mean moving all your assets into cash equivalents and bonds. Retirement isn’t the end and could last 20 years or more. Your money needs to grow throughout those years, and that means maintaining a stock allocation.
» New to stocks? Read my guide on how to invest in stocks
Once you have a time horizon and goal, consider your risk tolerance. Risk is necessary for reward, but be cautious and always make an informed decision, not an irrational one. The news will make situations look dire, but don’t let that ruffle your feathers. Otherwise, you’ll spend all day watching the markets go up and down worried.
Diversifying within each asset class helps reduce your risk significantly, without reducing your potential for returns. When you diversify, instead of buying one large-cap stock and calling that section of your asset allocation good – buy several large-cap stocks or even better, a large-cap index fund.
Make asset allocation easy
If you’re worried about asset allocation, some tools do it for you.
One is a target-date fund that holds a variety of stocks and bonds. Let’s say you plan to retire in 2050, so you would select a 2050 target-date fund. The fund automatically allocates your assets into a majority of stocks, but as the target-date gets closer, it automatically allocates more into bonds. One basic premise of the target-funds is to allocate your funds in riskier investments initially and shift them towards less-risky options as the date approaches.
Another option is a robo-advisor, such as M1 Finance, which asks you about your goals and risk tolerance. In return, it provides you a portfolio that fits the bill. From there, you can update your goals and risk tolerance and it will automatically adjust. Pretty freakin’ cool right?
» Want to open an account? Learn how and earn FREE $10
All in all, spread the love and your assets. Don’t put them all in the same basket.