Asset allocation is an investment strategy that spreads an individual’s investments over several asset types to reduce investment risk. It uses the risk and return of each asset as a guide to create a portfolio that, among other things, fits a person’s investment goals and tolerance for risk.
There is no single asset allocation that will work for everyone. Even two people in similar financial situations might find that different asset allocations are appropriate for them. That’s because the factors to consider when making an asset allocation go beyond simple finances. If you’ve read some of our previous articles on investing, you’ll likely recognize some of these factors:
- Financial goals – why are you investing?
- Length of investment – when will you need the money?
- Liquidity – how quickly will you need to cash out your assets?
- Risk tolerance – how willing are you to take on the volatile nature of investing?
Let’s take a look at a simple example.
Stocks are more volatile than bonds. On the other hand, they have historically shown to have a higher return than bonds. Thus, the above asset allocation theoretically has higher risk, but also has the potential for a higher return.
Though a down year in the market could really hurt this portfolio, the bonds could offer some stability and afford the investor the time to stay invested and wait for the market to recover. Such an asset allocation could be ideal for a young investor who is planning on investing for a long period of time, or someone who has a high tolerance for risk.
That said, things change. For example, as you near your goals (say, retirement) you may become more risk adverse; a big loss in your retirement funds is much more difficult to recover from at 60 than it is at 30. As such, it’s a good idea to re-evaluate where you are in life and in your career, and adjust your asset allocation to reflect your current situation.