Asset Allocation is the
process of determining optimal allocations for the broad categories of
assets (such as Stocks, Bonds, Cash, Real Estate, ...) that suit your
investment time horizon and risk tolerance.
While this process can be performed on any portfolio with
two or more assets, it is most commonly applied to asset classes. This
allocation is probably the most important decision and may account for
more than 80 % of the return of the portfolio.
Each asset class will generally have different levels of return and
risk. They also behave differently. At the time one asset is increasing
in value, another may be decreasing or not increasing as much and vice
versa. The measure used for this phenomenon is called the correlation
How to make asset
allocation work for you
By Jim Jubak
diversity to your portfolio, or asset allocation, helps you to control
risk and meet your financial goals. Here are four scenarios for mixing
the investments in your 401(k) as you plan your retirement.
You may not realize it, but you probably already practice
asset allocation. That's what you're doing if you buy bonds when
interest rates seem high, or you sell stocks when the equity market
feels risky, or you move assets into a money-market account in
preparation for a down payment or a big tuition bill.
But while we may practice a rudimentary form of asset allocation, most
of us don't get all we can from the approach. Asset allocation can help
an investor to control risk, to match a portfolio with specific
financial goals, to increase the predictability of returns and more.
The principles behind asset allocation are simple.
First, history shows that not all classes of assets move up and down at
the same time. One year, stocks of large companies may generate the best
returns, while in another it will be government bonds or even a bank
certificate of deposit.
History also tells us that some asset classes are far more volatile than
others. They may go from big gains one year to big losses the next,
while the performance of less-volatile counterparts remains within a
much narrower range.
If an investor could predict which asset classes would do best in any
specific time period, there would be no need for asset allocation. Such
a psychic would move into stocks when they're about to rack up a 30%
return, and move into cash when stocks are headed for a tumble.
Investors with an endless amount of time before they need their money
don't have much need for asset allocation either. Just put everything
into the asset class with the highest average returns over the long haul
and ride out the dips.
Who needs to allocate?
But asset allocation is ideal for those of us who aren't psychic, who
need money in the foreseeable future and who are prone to do silly
things if our net worth dips too fast. By balancing the types of assets
we own among stocks, bonds, and cash, we trade the best? returns we'd
get if we timed the markets perfectly for predictability and piece of
No one mix of assets is right for everyone all the time.
Those closer to needing their money may put a premium on predictability.
For them, an asset allocation that tries to minimize losses is a good
choice. But that same allocation would be a poor choice for a young
investor with 40 years to go before retirement. It sacrifices too much
potential return for safety that this investor doesn't need.