What Is Asset Allocation?
Asset allocation is an investment strategy to balance risk and reward. Here’s why it’s important and how it works.
Investing can bring great rewards over time, but it can also be risky. One way people mitigate risk is by employing asset allocation. This is a strategy where an investor divides their portfolio among several types of asset classes – namely equities, fixed-income, and cash and equivalents.
Asset allocation can be a smart way to balance risk vs. reward as you build your portfolio; however, it can be complicated. In this article, we’ll help you understand how this strategy works, as well as why it’s important. You’ll also learn about how it differs from diversification. Finally, we’ll explain why it may be a smart choice to hire a financial advisor to help with your investments.
Understanding Asset Allocation
Asset allocation is an investment strategy that involves splitting up your portfolio among various asset classes. How you allocate your investments will typically vary based on your current life situation. More specifically, the classes you choose tend to rely on your:
- Risk tolerance. How much you’re willing and able to lose on a specific investment in exchange for potential returns later on.
- Goals. Your short- and long-term investment goals will play a large part in deciding what asset classes you allocate funds to. For example, if you want a fixed income over a certain period, you may want to invest in bonds. Or, if you want higher returns and have a higher risk tolerance, stocks may fit into your portfolio.
- Time horizon. This refers to how much time you have to reach for goals. For instance, if you’re close to retirement, lower-risk investments may be smarter, so you don’t jeopardize your future.
Once you have an idea of what you want to invest in, you’ll allocate funds to a certain percentage of each asset class. This allows you to have proper diversification and balance in your portfolio.
Why It’s Important
Asset allocation is an important strategy for several reasons. First, it allows you to balance risk and reward in your portfolio. In other words, it helps you mitigate losses, while also allowing you to see potentially significant returns on investment (ROI).
Also, allocation offers you the ability to sufficiently diversify. This is crucial because, if one asset class suffers, it won’t impact your entire portfolio. You’ll also be more prepared for any changes in the market cycle because you aren’t dependent on just one class type succeeding.
The proper allocation may also help your portfolio perform well and grow in the long term. A study by Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower (or BHB for short) found that asset allocation resulted in 90% of portfolio variability over 9 years.
Types of Asset Classes
An asset class refers to a grouping of similar economic vehicles. There are four major types you can dedicate funds to within your investment portfolio. Each comes with unique advantages and downsides as you implement your allocation strategy:
Equities, or stocks, are securities that allow you to buy shares of a company. You can own equity in either private or publicly traded companies. As a firm’s overall value appreciates, so too will your ownership stake.
The risk with equities, however, is that several factors can cause you to lose money. The stock market can fluctuate, and if your shares depreciate, you could take a loss. You’re also betting on a company’s continued growth and good performance, which may not always hold up long-term.
Fixed income, or bonds, are a type of security that pay you back after a certain period (at maturity), plus interest. Basically, they’re a loan from you to a company. They’re a way you can create regular income through interest payments. You’ll also find that they’re relatively low risk, as you’re usually guaranteed to receive your initial investment.
But because of their low risk, bonds normally don’t yield high rewards. And, in the rare case that a company can’t pay you back, you may lose your investment. You may also buy and sell these before the maturity date occurs, but you may end up losing money if you sell at the wrong time.
Cash and Cash Equivalents
Investing in cash is another option you have. Often, when market conditions are volatile, you’ll see people hold on to cash because of its liquidity. However, it is subject to a loss in value over time due to inflation.
Cash equivalents refer to securities such as commercial paper, Treasury bills, and money market funds. These investments don’t offer huge returns but are lower risk. Like bonds, you should keep in mind that you may lose your investment if the company is unable to pay you back for your initial investment.
These refer to physical objects of which you can buy and own shares. For most people, real estate properties come to mind. But it can also include objects like oil, gold, silver, or wheat. Like stocks, these can rise in value and provide significant returns over time. You may also receive regular income, such as from REITs or rental properties you own.
Keep in mind that real assets are also subject to ever-changing market conditions. If the real estate market goes down, your property’s value likely will as well. Interest rate changes are also a risk to watch out for.
There often isn’t a one-size-fits-all asset allocation approach. Normally, an advisor will apply a specific approach tailored to an investor’s situation and preferences. Below are the most common strategies you’ll see:
The strategic approach allocates assets with a focus on the long-term, while also keeping your risk tolerance and goals in mind. Because the objective is to keep the same allocation in place over a long period, this strategy typically disregards outside conditions, such as the market or the current economy.
The dynamic allocation strategy emphasizes creating a blend of assets the balances risk and reward long-term, much like the previous approach. As the name suggests, dynamic strategies will adjust over time to outside economic conditions that may affect certain investments.
The tactical approach considers both short- and long-term investments, so long as one maximizes their returns. It’ll typically call for picking asset classes that allow you to make bigger gains. And, like the dynamic strategy, there’s more freedom for you to constantly adjust your portfolio according to market and economic conditions.
With the core-satellite strategy, you’ll combine both passive (index funds, ETFs, etc.) and active investments (stocks) to build a well-rounded portfolio. Like the others, the goal is to create a balance of risk and reward. Passive investments allow you to mitigate risk, while active investments allow you to see bigger returns.
Asset Allocation vs. Diversification
Asset allocation refers to spreading your money around to different classes, such as stocks, bonds, real estate, and cash. In practice, it allows you to protect yourself from market volatility, as well as balance risk and returns. However, it technically isn’t the same as diversification.
Diversification is a concept where you spread funds around to different types of securities or investments. It refers to diversification within a certain asset class, or across your entire portfolio. Doing so protects you from one type of security’s decline significantly impacting your portfolio.
As an example of diversification balancing risk, consider stocks and bonds. Typically, the two types of securities won’t increase or decrease in value at the same time. So, by owning each, you mitigate the overall risk.
What Is Rebalancing?
Whatever asset class you choose to invest in, it’ll be at the mercy of outside market or economic conditions. This is why it may be smart to consistently adjust or rebalance your allocation within your portfolio to lessen risk.
With asset allocation, the goal is to maintain the same blend over time to sustain results. And, as mentioned, market conditions could cause an investment to rapidly grow or decline in a way that doesn’t align with your strategy. Depending on your approach, you or your advisor will typically rebalance once something seems out of order.
For example, imagine you want 60% stocks, 20% bonds, and 20% real estate in your portfolio. If a stock rapidly rises in value, you may need to sell it or buy from other asset classes to maintain your intended mix. Ultimately, this is a way to keep your portfolio in check and ensure no imbalances.
Role of a Financial Advisor
Investing is a worthwhile endeavor, but it can be hard for the average individual. Financial advisors can help you pick smart investments and avoid crucial mistakes so that you can reach your goals. Asset allocation is also something they’ll be able to help with. As you meet with an expert, they’ll work with you to identify a strategy that fits your goals, then put it into action.
Finding the right advisor is important. You’ll want a fiduciary that prioritizes your needs over their own. To find one, consider using this free matching tool, which will present you with up to three vetted professionals near you.
Frequently Asked Questions
What’s the difference between asset allocation and diversification?
Asset allocation refers to dividing your portfolio amongst several types of classes to balance risk and reward. Diversification, on the other hand, focuses on buying individual types of securities, either within a class or across many.
What is tactical asset allocation?
This is a strategy that focuses on buying short- and long-term investments that maximize returns. It also allows you to rebalance your portfolio as market and economic conditions change.
What is an asset allocation fund?
What is the primary goal of asset allocation?
The primary goal is to mitigate risk and maximize returns over a long period. By spreading your funds around to different types of assets, one’s decline shouldn’t adversely affect your portfolio.
Find a Financial Advisor
Take our quiz and be matched with up to 3 vetted fiduciary financial advisors serving your area. It's fast, free, and no-obligation.Compare Vetted Advisors