What is asset allocation and how does it work?
Mathias Darnell/EyeEm/Getty Images
Asset allocation is how your assets are spread across different asset classes to reduce risk and potentially increase your returns. Each type of asset – stocks, bonds, and even cash – behaves differently over time, and smart asset allocation involves creating a portfolio that maximizes your long-term return and minimizes your risk while you’re investing in it. reach.
Savvy investors use asset allocation to create a portfolio that meets their financial needs and temperament, taking into account their risk tolerance, time horizon and need for investment return.
Here’s what you need to know about asset allocation and how it can benefit you.
How Asset Allocation Works
Asset allocation depends on asset classes with different characteristics. Each asset class can behave differently when an economy moves in a particular direction. As the economy expands, some assets increase, while others may remain stable or even decline, depending on specific circumstances.
This quality of non-correlation allows investors to build portfolios that zigzag when the market zigzags. By mixing and matching the qualities of asset classes, an investor or financial advisor can make a portfolio less volatile and potentially achieve the same or better returns than a riskier portfolio. Asset allocation takes advantage of the principle of diversification to reduce risk.
For example, if you are 30 years before retirement, you can afford to take on more risk in exchange for the higher potential returns available in the stock market. Thus, a financial advisor or robo-advisor would generally recommend a higher allocation to stocks and less to low-yielding bonds.
However, as you approach retirement, an advisor can gradually transfer you to safer assets, such as more CDs or bonds. CDs offer guaranteed returns, a valuable feature when you need low risk.
What are the important asset classes?
Below are some key asset classes and some general characteristics of each:
|Shares||High risk high return. Stocks can come back the most over time, but will fluctuate the most along the way. Some stocks are less risky than others, such as dividend stocks. Stocks tend to do well in a growing economy and poorly in a weak economy.|
|Obligations||Bonds pay regular interest income and tend to be relatively stable. Bonds are generally much safer than stocks, although the performance of the bond depends a lot on the quality of the issuer (government, corporate or others).|
|Immovable||Real estate comes in many forms and you can make money on price appreciation as well as income. Physically owning real estate can have a different risk-reward profile than buying it through a real estate investment trust on the stock market, and can also involve a lot more work. Real estate tends to appreciate slowly over time while throwing money away.|
|Cash||Cash is the most stable asset of all, but it receives very low returns and loses value due to inflation over time. However, it is extremely important during a downturn as it can get you through an emergency and can be invested in assets that have fallen in value. A high-yield online account can maximize its value.|
|Gold||Gold is a popular investment that often does well when the economy is struggling or when other assets are doing poorly. Many investors use gold as a hedge or store of value, especially when they think inflation might rise due to the government printing more money.|
|Alternative assets||Alternative assets include private equity funds, dark precious metals, farmland, art, and anything that investors believe is uncorrelated to broader markets. Non-correlation is often the key to what is classified as an alternative asset.|
More recently, some investors have turned to Bitcoin and other cryptocurrencies to incorporate other uncorrelated assets into a portfolio. However, some investors, including investing legend Warren Buffett, think these investments are nothing more than junk.
How do you use asset allocation?
You can use asset allocation in many different ways, and you might already be using it without thinking too much about it. For example, if you own your home and invest in the stock market, you are already using asset allocation, even if you are not taking full advantage of it.
However, many financial advisors will more strategically build portfolios with their clients. They will create a financial portfolio that balances your needs with your risk toleranceand ideally they will make the portfolio more stable, at least for the level of risk you are willing to take.
A robo-advisor typically uses asset allocation to build a portfolio that matches a client’s risk tolerance and time horizon, after asking them a series of questions about these topics.
If you’re looking to use asset allocation yourself and don’t have a lot of experience with it, an alternative is a target date mutual fund. A target date fund does the allocation for you, and they’re usually offered in employer-sponsored retirement plans, such as 401(k). With these funds, you select the date when you need the money – say, 2045 – and then the fund gradually adjusts the assets over time so you have greater security as they become reliable for a short term income.
At the end of the line
Asset allocation is one of those investment principles that seems so simple but can be more difficult to implement due to the various characteristics of asset classes. And advisors of all kinds base their asset allocations on historical asset performance and volatility, so there are no guarantees as to the future performance of any asset class.