What Is Asset Allocation and Why Is It Important?

One of the things that investment gurus always emphasize is to diversify, diversify and diversify.   Supposedly, diversification will help improve the overall performance of your portfolio since it doesn’t ride on just one investment vehicle. The trouble now is this, with over thousands of stocks, bonds, and mutual funds to choose from, how can we correctly pick the right investment?

 

Some investors may end up studying different companies that sell stocks in order to choose the best stock picks, but doing so may just be the wrong approach. Instead, an investor should decide on what mix of stocks, bonds and mutual funds you would like to hold. This type of strategy is called asset allocation.

 

What Is Asset Allocation and Why Is it Important?

 

Investing always rides on a certain amount of risk. The more risk an investor is willing to take, the more returns he is bound to get. However, risk is also associated to loss.   There are certain types of asset classes that are more prone to risk but will also give higher returns, while there are also asset classes that give less in returns but are considered to be generally safer.

 

Asset allocation is a type of investment technique that attempts to balance the risk and return ratio by diversification. Meaning, an investor’s assets will be divided into different categories such as stocks, bonds, cash, real estate, and derivatives.   Since each asset class has different returns and risk, each will behave differently over time. Some assets in a certain class may perform well at a particular period while others may not.

 

For example, local real estate may be booming, while the stock market may be experiencing some volatility. The rationale towards allocating your assets is that whether the market at one type of investment class may be experiencing problems, your assets from other classes will still pull your portfolio up.   There are however some investors who deem this method to be mediocre, however, most investors generally see this method as the best protection against major loss. Below are the different types of asset classes that each investor must have in their portfolios.  

 

Common Investment Choices   Stocks

 

Among all the asset classes, stocks by far offers the highest returns. In exchange for this, stocks also have a history of high volatility, making it one of the riskiest investment vehicles available. As of January 13, 2011, there are currently 2,872 listings in the NASDAQ.

 

Each stock pick offers different returns, and it depends upon the investor which type of stock he would choose. The stock market is characterized by a trade-off between risk and return, the higher the risk that an investor is willing to undergo, the higher the potential of reward.   Despite high returns and dramatic losses, stocks have shown positive returns as long as the investor has the time to ride out the volatility of the market. And although each stock pick will have varying return on investment rates, the average growth of stocks is around 10-12%.

 

Bonds

 

Bonds in general are considered to be less risky than stocks. First of all, bonds give a promise to return the value of the security at the time bought upon its maturity. Stocks do not offer such a promise.   Bonds also pay investors a fixed rate of interest while stocks only offers dividends should the company declare it.  And finally, the bonds market is less vulnerable to price swings than the stock market.


 

Because bonds offer less risk to the investor, then it also follows that this type of asset class provides lesser returns. Bonds can be issued by the Government such as the U.S. Treasury, it can also be issued by the state, and corporations.   However, there are also bonds that offer higher returns that are similar to stocks, but these bonds are also known as junk bonds which carry high risk.An investor may be attracted to include more bonds in his portfolio especially if he does not have as much time to offset the volatility of stock markets.   Bonds can be a good place to invest for those who are nearing retirement or who need to use their cash at a sooner time.

 

Cash


 

Cash and cash equivalents include savings accounts, certificates of deposits, treasury bills, money market funds, and money market deposit account. This type of investment is the safest and carries the least risk especially since accounts such as these are usually insured by the FDIC for amounts up to $250,000.

 

However, these accounts also offer the lowest returns. The concern that investors face with this type of investment is inflation risk. Meaning, the returns that these accounts offer may not be enough to outperform the potential inflation.   Depending on the economic situation, interest rates for these types of investment range from less than 1%-3%, depending on the length of the term.  

 

Real Estate

 

Although stocks, bonds, and cash are the most common types of investments, it is possible to include real estate in your portfolio. Real estate is considered to be one of the most stable types of investments that also offer high returns.   Recently however, the housing market has encountered losses because of the 2008 recession, and until now it has yet to show signs of recovery.

 

In a study conducted by a finance and economics professor at Baruch College in New York City, the annual returns of real estate from 1978 to 2004 had an annual returns of 8.6%, while stocks showed a long term performance of 13.4%.

 

Commodities

 

There are still other forms of assets such as precious metals, and some investors may consider including these types of assets in their portfolio.   Gold has also been gaining attention now that the stock market is so volatile. By investing in assets that move up or down under different market conditions, investors can protect themselves from significant losses.

 

In the course of history, the returns of the four asset classes mentioned above have not moved up or down at the same time.Investors also have to consider the amount of time until they plan to use the money they invested.   Typically, those who are still young and have time to recover from an economic downturn, can afford to place investments in high risk high return assets since they can afford to wait if in case the market goes down.

 

Reader Actions!  

 

Leave a comment below discussing your current asset allocation for your portfolio.  This can be for taxable accounts or retirement accounts.  Also, let me know why you are investing in those particular assets.

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Comments

  1. I usually use a more adventurous investment play 1/2 on shares 1/2 on bonds and I've done alright for myself
    Money Infographics recently posted..The Extra Dollar [Infographic]My Profile

  2. Nice article. I have invested 80% of my assets in stocks and 20% in the bonds. I am contemplating idea to increase my bond holding in next year or so.
    Shilpan recently posted..4 Tips to Boost Your Self-ConfidenceMy Profile

  3. One must be careful when looking at commodities. Though there can be some great opportunities in commodities [ie oil after the 2008 crisis] if one doesn't truly understand the drivers of commodity prices losing money can be very easy.
    Ron recently posted..The Difficulty of Investing In the Modern AgeMy Profile

  4. I'm all for stocks right now, this is the best time to get in because over time, all stocks go up. But investing most of your assets in stocks is only good when you are young and have extras lying around. When you are older, it is taking a BIG risk and I wouldn't advise it.
    Aaron Hung recently posted..Change Your Ways with Money Without StrugglingMy Profile

  5. I know that diversification is the single most important factor besides time for investment success however I recently moved most of our investments out of equities. The debt crisis in Europe and the lack of political will in Washington to tackle our own debt crisis does not bode well for equities. I'll be watching the politicians to see what fiscal policy decisions are made and then decide when to get back in.
    Paul @ The Frugal To recently posted..New Credit Laws Take EffectMy Profile

  6. I agree that asset allocation is important. However, for some reason or another it is difficult to do properly. I myself am having trouble with this. Right now in my 401K, more than 50% is in cash. I know this is wrong but I just can't seem to find the right time to get back into market. On top of this, I have about 30% in my company stock. This also is wrong thing to do. Talk about making all sorts of mistakes. I know I need to fix this quickly but a struggling to do so because I haven't found balanced allocation for me…
    UltimateSmartMoney recently posted..Can We Become A Millionaire Just By Avoiding Cars?My Profile

    • There will never be a right time to get into the market. Staying on the side lines you will be losing money due to inflation.

      So, your portfolio is 50% cash, 20% company stock and 30% other. This is a very very risky portfolio especially the company stock..

      Talk about making all sorts of mistakes. I know I need to fix this quickly but a struggling to do so because I haven’t found balanced allocation for me…

      Have you tried some of the free tools and vanguard.com? A lot of the brokerages will help you identify a proper asset allocation based on your risk tolerance and investment time frame.

      I suggest you do this immediately, I would hate for your to miss out on gains or experience losses that you don't need to face.

      • Yea, I know… this is not good. I am hoping to get back into stock market soon. Just waiting for the market to drop again just like this week. I will go back if the market continues to slide into next week. I got out back in August so I actually made some money since then. But I failed to realize that it is hard to get back in for some reason, mainly greed.
        UltimateSmartMoney recently posted..Can We Become A Millionaire Just By Avoiding Cars?My Profile

  7. Looks like you're very broad in your investment approach. I'm curious what is your investment time period? Also, why go for individual stocks instead of funds?
    YFS recently posted..What Is Asset Allocation and Why Is It Important?My Profile

  8. I try to reach all the broad assets and I add healthcare, biotech, high tech and a few individual stocks. Heathcare traditionally is one of the safer areas of the market. I like biotech and high tech because of its potential.
    krantcents recently posted..Money or Your Life?My Profile

  9. Where do "derivatives" fall? Where do mutual funds fall? How about whole life insurance that has a cash component?

    Thanks! Peace.

    P.s. Right now I'm more concerned about cash even tho if I managed to save $250,000, 20 years down the road it wouldn't be worth as much. But I went to the following inflation calculator: http://www.bls.gov/data/inflation_calculator.htm. And to equal the buying power of $250,000 20 years ago in 1991 one would need $415,603.89 today. I don't think that's horrible since it's not double.

    • A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties. The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset.

      The underlying asset can be securities, commodities, bullion, currency, live stock or anything else.

      In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

      In essence, derivatives; mutual funds; whole life insurance; variable life insurance; IRA; 401k; ETF's; and the various index funds are the vehicles in which the assets are placed in. There are different rules and regulations placed upon these investment vehicles.

      If you're worrying about inflation you need to invest to make more than inflation :-). But, invest safely and according to your risk tolerance and investment time period.

      What are you investing in now?

  10. You have a great start above on describing the different types of vechicles to use to diversify. Don't forget that geographic diversification is also important and that even within the different classes you list, there are subdivisions – for example bonds can be global, domestic, corporate, tax free and etc.
    Marie at FamilyMoney recently posted..FamilyMoneyValues Around the WebMy Profile

    • You're 100% correct. There is quite a bit more to asset allocation than what I listed above.

      Can you specify how your portfolio breaks down percentage wise?

  11. This is quite interesting – I have been diversifying not only between various assets but currencies as well.

    http://www.niterainbow.com/2011/10/diversificatio

    It is amazing how portfolio behaves itself – it is much more stable, but less performing (volitile)…

    I have not personally observed stocks delivering 10-12% over last a few years, but you really need to look over longer period of time. Two curious facts about the stocks:

    - Only 202 of the 500 biggest companies in the United States in 1980 were still in existence 20 years later.

    - On December 29, 1989, Tokyo's Nikkei stock average reached its all-time peak of 38,915.87. Twenty years later, the Nikkei has never again reached that level — and, in 2009, reached a new low of 7,054.98.
    Financial Independen recently posted..Inflation influenceMy Profile

    • Stocks have a long term trend of performing in the 10-12% range. Long term as in about 30 years. The market swings of last decade definitely will test this theory. But, as they say past gains do not predict future gains.

      I have yet to do anything with cinctures so can you specify which currencies you are investing in and why? How much of your total portfolio is in currencies?

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  12. olddogg.com says:

    What Is Asset Allocation and Why Is It Important? | Your Finances Simplified…

    One of the things that investment gurus always emphasize is to diversify, diversify and diversify. Supposedly, diversification will help improve the overall performance of your portfolio since it doesn’t ride on just one investment vehicle. The trouble…

  13. fwisp.com says:

    What Is Asset Allocation and Why Is It Important? | Your Finances Simplified…

    The trouble now is this, with over thousands of stocks, bonds, and mutual funds to choose from, how can we correctly pick the right investment?…

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