Asset Allocation

How your money is allocated in your investment account is the key to performance, risk, volatility, and reaching your financial goals.

Asset allocation is one of the most important investment strategies within your financial plan. It is crucial to have the right asset allocation in each investment account because it has a significant influence on performance, risk, and volatility. A good asset allocation can be the difference between reaching your financial goals or falling short, but it requires emotional discipline to consistently do.

What is asset allocation?

Asset allocation, simply put, is choosing what your money is actually invested in. There are four primary asset classes— stocks, bonds, cash and equivalents, and alternative investments. Deciding how you want to allocate your money is solely based on the amount of risk you want to take to reach your financial goals.

Tips to Know:

• Stocks can help your money grow the fastest, but that comes with a higher possibility that you could lose money.
• Bonds help your money grow at a slow fixed rate and can have a lower risk than stocks, but it’s not risk free because of things like bond issuer defaulting.
• Cash and cash equivalents (treasury bills, certificates of deposit, savings deposits, money market deposit accounts or funds) have the lowest returns but provide the most liquidity (ability to access your money quickly) and are the safest investment option to get your money back. However, with cash and equivalent investments, you need to be wary of inflation risk. This means the value of your investment might not increase at the same rate as inflation.
• Alternative investments are commonly commodities and real estate. Alternative investments also include private equity, hedge funds, venture capital, antiques, and option contracts. Alternative investments are a good way to hedge risk as their prices increase when the market prices decrease. One thing to keep in mind is that alternative investments can be complex.

Diversification

Two common themes that you will hear regarding asset allocation is diversification and rebalancing. Diversification is putting your eggs in different baskets (asset classes). You can also diversify within sub-classes of the major asset classes such as small-cap and large-cap stocks. To ensure that your money grows without being too dependent on one investment or asset class, a good investment strategy allocates your money into different investments across different asset classes. A properly diversified portfolio has the potential to provide consistent returns with lower risk than just holding one company’s stock.

Even with good diversification, over time, your portfolio may stray from your desired allocation. Rebalancing is a way to keep your desired allocation by selling and buying investments in your portfolio as they go up and down in value.

A good example of this is a ship heading from New York to London. It starts with a direct course but over the voyage, winds and storms will push it off course so the captain (like a proactive Financial Advisor) will steer it back on course to get to the destination.

Risk & Time

Determining the proper asset allocation for your account depends on several factors. Risk tolerance is a primary factor in considering what assets are in your investment portfolio. If you want a higher return and are comfortable with higher risk, then your portfolio will have a higher percentage of stocks. If you are more conservative, your portfolio will have a higher percentage of bonds and/or cash equivalents.

Age can also be another significant factor in determining your asset allocation. When you are younger, you have a longer time horizon (time that your investments have to grow). This allows you to focus more on growing your wealth rather than protecting it. So even if your investments don’t do well in the beginning, you have time to let them rebound because you won’t be at retirement for decades yet.

Removing Emotion

The greatest challenge of rebalancing to your original asset allocation is removing emotion. As the market moves and one asset class goes up, your portfolio will become out of balance, so you need to sell that asset class to get back to your original target percentage. At the same time, you need to buy the one that is going below it’s target percentage. Simply, you have to sell the winners and buy the losers. This makes sense mathematically and proves out over time as the way to capture the target return you may need but it certainly never feels good emotionally.

How asset allocation impacts you

Asset allocation keeps your investments properly aligned with the risk you are willing to take to reach your goals on time. By allocating your investment accounts properly, you can make sure you are getting the return you want or need with the proper amount of risk.

It’s important to look at how your retirement or investment accounts are allocated every other year because your goals or timeline or risk tolerance may change over time. Some portfolios will automatically rebalance or funds like a target date fund will automatically rebalance which saves you the need from checking your allocation each year. Target Date funds will even become more conservative for you simply as you get closer and into retirement.

Key Takeaways

Asset allocation is one of the most important tools to help you reach your financial goals. Making sure that the fuel driving your accounts (investments) are properly diversified and aligned with your financial goals and risk tolerance will help you reach your financial goals with clear expectations. Don’t forget to rebalance back to your desired allocation and be sure to check your accounts allocation at least once a year.

Disclaimer: This post is for informational purposes only and is never to be taken as advice or a recommendation. Talk to a tax or legal professional to determine how this information best applies to your personal situation.