Asset allocation is a term that’s thrown around in the financial world quite often. There’s a reason for this.
It makes all the difference. Having the correct asset allocation can not only help you reach your investment goals, it can make sure you are comfortable on the ride to those goals.
Let’s learn more about asset allocation.
What is asset allocation?
Investopedia defines asset allocation as an investment strategy that apportions a portfolio’s assets according to an individual’s goals, risk tolerance, and time horizon.
To put it simply, if you’re tolerant towards risk and have a long time horizon, you’re more likely to have a larger allocation in aggressive investments.
Conversely, if you’re risk averse and have a shorter time horizon, then your portfolio will have a conservative tilt to it.
The big three
There are a variety of assets you can invest in, but the three big ones are stocks, bonds, and cash. Typically, the makeup of your portfolio is shown as a ratio of stocks/bonds/cash.
An example allocation would be 60/30/10.
- Stocks - Of the three, stocks are the riskiest, but also offer the highest reward. Historically, investing in stocks has proven to significantly outpace inflation over the long-term. During the short-term, however, they tend to be volatile and can hurt your portfolio if the market turns south.
- Bonds - Generally, less risky than bonds (though it can depend on the bond) and therefore, offers less return than stocks. However, bonds tend to experience less volatility over the short-term.
- Cash - “Risk-free asset.” The value of cash will stay the same, without any volatility. However, there’s a significant amount of purchasing power risk - inflation will eat away at your cash, so your money today will buy fewer goods in the future. It’s a good shock absorber, but not a good place for long-term investing.
Risk tolerance and time horizon
Paired with goals, risk tolerance and time horizon, are the biggest factors when discerning what your asset allocation should be.
If you are risk averse and can’t stomach the swings in the market, you should probably be a little more conservative.
If you’re tolerant to risk and are able to handle the ups and downs, you can probably be more aggressive.
What about time horizon?
If you have decades to invest, then you can afford to be more aggressive because you have more time to recapture any losses you incur.
If you have a short-term time horizon (definition of short-term varies from person to person) then you probably want to be more conservative because, unlike the long-term investor, you don’t have time to get back your losses.
Changes through time
Your risk appetite and your time horizon will change through time. If you start as a long-term investor, as you get older, your time horizon will shrink. As you get closer to retirement, you’ll need to be more and more conservative.
Also, certain investments in your portfolio will outperform and will pull your allocation from where it started.
For instance, if you began with a 70/25/5 allocation and let it go for 10 years. Odds are, your stock portion will increase and the other two will decrease relative to your overall portfolio.
Rebalancing annually or biannually might not be a bad idea. That way, your allocation always matches your time horizon and risk tolerance.
*By the way, goals, risk tolerance, and time horizon are often lumped together as one term - suitability.
Asset allocation truly does matter. It makes sure your portfolio aligns with your suitability, so you are able to meet your goals and stay (relatively) comfortable along the way.
In the most extreme cases, having a portfolio allocation that doesn’t align with those things could prove dire to your financial life and your investor psychology.