Understanding Asset Allocation

Asset allocation is the thoughtful use of assets (investment capital) to balance risk and reward across your holdings. Typically, investors have three classes of assets: securities, fixed-income assets, and cash. This is where you should start. More sophisticated forms of asset allocation add other classes of assets such as real estate, precious metals, and so on. The vast majority of investors need only concern themselves with the three basic classes. Diversification is often used as a synonym for asset allocation, but it has a more narrow focus.

Asset Allocation and Diversification

Asset allocation and diversification are both strategies to reduce risk. Asset allocation involves how all three asset classes work together to manage risk and improve returns. Diversification refers to how you structure each class for the best results. For example, asset allocation looks at the percentage of each asset class in your portfolio (stocks—60 percent; bonds—20 percent; cash—20 percent). Diversification considers how you spread your stock investments over several industrial sectors (tech—10 percent; financial—35 percent; retail—15 percent; consumer goods—15 percent; utilities—25 percent). To avoid extra explanations, I will simply refer to asset allocation and you can assume I am including diversification as part of the process.

The Importance of Asset Allocation

As “jargony” as asset allocation sounds, it is incredibly important to your success as an investor in the stock market. Many studies have confirmed that finding the correct asset allocation is as or more important than the securities you buy. This means even if you do the best job of picking stocks and other assets, you still may not achieve the return you expected if your asset allocation is wrong.

Here’s why this is true. Stocks and bonds (the fixed-income asset class in most cases) frequently move in different directions. Economic circumstances that may drive down stock prices tend to increase the value of bonds and when stocks are rising, the value of bonds may suffer. If you have a good balance, your portfolio may not suffer as much if one asset class drops, because it is likely the other will rise. The opposite is also true: if stocks take off on a steep rise, you may not achieve the same results with a portfolio balanced with all three asset classes, because bonds may fall in value.

This is the balance between risk and reward that asset allocation brings to your portfolio. Because the future is unknowable, your best chance of success is to build your portfolio with an asset allocation that achieves the balance between risk and reward that is comfortable for you. There is no one “correct” asset allocation. Investors must decide for themselves what makes the most sense for their circumstances and tolerance for risk.

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