What Is Asset Allocation? A Beginner's Guide to Investing

Asset allocation is one of those terms that gets thrown around a lot when people start talking about investing. If you were to ask 10 financially savvy individuals what it takes to be successful in investing, chances are good that at least half would tell you something along the lines of, “It’s all about proper asset allocation.”

To seasoned investors, it’s a religious creed; to beginners, it’s an ideal to be strived for. But what does it really mean, and how does it impact you and your investment goals?

Asset allocation is all about balancing investment risk against reward. The more risk you take, the more potential you have to make money on your investments. But more risk means you could also lose more money. Most investors try to find a balance between the two.

1. ASSET CLASSES

   Before we get into asset allocation itself, let’s talk about asset classes. Asset classes are the different categories of investments. The three most common asset classes are stocks, bonds, and cash or cash alternatives. Generally speaking, investors choose asset classes based on two criteria: how risky the investment is, and how much potential for return the investment has.

   Stocks can be risky investments; their values tend to fluctuate, sometimes wildly. In any given year the S&P 500 (which is an index of 500 stocks), could be way up or way down. But on average, over time, it has been up. In fact from 1928 to 2016, the average yearly return on the S&P 500 was more than 11 percent. You invest in stocks in a portfolio for the potential for growth over time, but they could cause it to lose value.

   Bonds are generally viewed as safer than stocks. Their values usually do not fluctuate as widely. Because of this, they typically don’t earn as much as stocks (long-term, 10-year government bonds, for example, have returned an average of about 5 percent between 1928 and 2016). Investing in bonds will typically help balance your portfolio, however, there are risks.

   Cash and cash alternatives are exactly what they sound like. Cash is cash, while cash alternatives are short-term investments that you can easily turn into cash — think money market funds and certificates of deposit. Because these assets are more unlikely to lose value, they typically don’t make much money for you. In fact, because things tend to cost more over time, having too much cash can actually work against you as the value of your money won’t buy as much in the future. Still, it’s a good idea to have a portion of your portfolio in cash so you can always have easy access to some of your money.

2. ALLOCATING YOUR INVESTMENT DOLLARS

   Now that you understand the basics about the main asset classes, let’s talk about how you allocate your investment dollars between the three.

   You could put all your investment dollars in cash. It’s unlikely you’ll ever see the dollar value of what you have invested go down. So if you need the money you saved, it’s all likely to be there. But over time, you won’t be able to buy as much with those dollars. For instance, a gallon of milk cost $2.55 in January of 1996, according to the Bureau of Labor Statistics. By January 2016, a gallon of milk cost $3.31. Those kind of price increases actually decrease the value of cash over time.

   The more risk you take, the more potential you have to make money on your investments. But more risk means you could also lose more money.

   You could put all your investment dollars in stocks. Remember, the average yearly return on the S&P 500 was 11 percent — but that’s an average over a long time. Also keep in mind past performance is no guarantee of future results, and you can’t invest directly in an index. At any given point in time, you could have less money. That’s because some years stocks go way down (think 2008).

   The goal of asset allocation is to balance your mix of stocks, bonds and cash for two things: how much loss you can take emotionally (risk tolerance) and when you might need your money (your time horizon).

   Risk tolerance is all about your ability to deal with loss. If you invested $1,000, could you deal with it being worth $500? If the answer is yes, then you have a higher risk tolerance and may be more comfortable with a larger mix of stocks than bonds or cash. If the answer is no, then you would want more cash and bonds than stocks.

   Time horizon is about when you’ll need the money. If you plan to use the money you’re investing within two years to send your child to college, you probably want to take less risk (it’s not helpful if a $50,000 investment drops to $25,000 as your child opens an acceptance letter to her favorite school). However, if you’re not planning to use your investments for 20 or 30 years, it probably makes sense to take more risk now and ride out the downturns in stock fluctuations so that you can take advantage of the potentially larger gains stocks can provide over time.

   A financial planner or professional can help you think through your risk tolerance and time horizon and then translate that into an asset allocation — an example of an allocation is 60 percent stock, 30 percent bonds and 10 percent cash.

3. REBALANCING

   Over time your allocation is likely to get out of whack. That’s because you may earn more on stocks than bonds or cash over a period of time and end up with 70 percent stock, 25 percent bonds and 5 percent cash. At that point, it may make sense to rebalance your portfolio. That means you sell some of your stocks and keep more in cash and purchase more bonds to bring your allocation back to its original 60/30/10. Selling investments can have an impact on your taxes, so it’s important to consult a tax advisor.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. This also holds true for bond mutual funds. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds or market value of bond funds that you own. At maturity, however, the issuer of the bond is obligated to return the principal to the investor. The longer the maturity of a bond or of bonds held in a bond fund, the greater the degree of a price or market value change resulting from a change in interest rates (also known as duration risk). Bond funds continuously replace the bonds they hold as they mature and thus do not usually have maturity dates, and are not obligated to return the investor's principal. Additionally, high yield bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds. Bond and bond fund investors should carefully consider risks such as: interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund.