Asset allocation is an important part of building an investment portfolio. This is because you need to decide your mix of investment assets, which may include stocks, bonds, and cash, before you choose specific investment securities.
Here's what you need to know about the basics of asset allocation and how it relates to diversification.
Defining Asset Allocation
Asset allocation refers to the mix of investment assets held in a portfolio, such as stocks, bonds, and cash.1 Determining how to divide your assets is one of the first steps in forming an investment objective, such as saving for education or retirement. After deciding on your asset mix, you can then choose specific investments.
Choosing Your Asset Allocation
Your asset allocation depends on two main factors: your holding period and your risk tolerance. These are based on your personal preferences, so your approach may look different from someone else’s. Before choosing your asset allocation, you need to measure and plan for the following:
- Holding Period: This is the amount of time you plan to keep your investment assets. It can also refer to the time before you begin making withdrawals from your investments.
- Risk Tolerance: This reflects how much risk you are comfortable taking. For example, someone with a low tolerance for risk may choose to invest a smaller portion of their portfolio in stocks, which can have more price changes over time.
Before choosing an asset allocation, measure and plan for both your holding period and your risk tolerance.
Asset Allocation & Stock Diversification
Asset allocation is the foundation of diversification. Diversification is the strategy of spreading investments across different assets and investment types.2 The first step is choosing your asset allocation, which defines your mix of asset types. The second step is selecting the specific investments within those asset types.
Here's an example of these two basic steps:
- Determine Asset Allocation: An investor chooses an allocation of 75% stocks, 20% bonds, and 5% cash.
- Determine Investment Types: After setting the allocation, the investor selects investments within each asset type. For example, within the stock portion, the investor may choose mutual funds across different categories such as large-cap, small-cap, and international stocks.
A mix of assets can strengthen your portfolio. However, diversification does not guarantee profit or prevent losses during market declines.
Why Asset Allocation Is Important
When building a portfolio, an investor controls both asset allocation and investment selection. Between these two factors, asset allocation often has a greater effect on total returns, especially over longer time periods. In simple terms, your mix of stocks, bonds, and cash may influence your results more than your choice of individual investments.
For example, someone investing for retirement in 20 years may expect a portfolio with 85% stocks and 15% bonds to perform differently than one with 65% stocks and 35% bonds. This is because stocks have historically produced higher returns than bonds. Keep in mind that investments do not guarantee growth or protect the value of your principal. They can lose value over time, and past performance does not predict future results.
The Bottom Line
Building a portfolio can be straightforward, but each investor has different goals and risk tolerance. For this reason, some investors choose to work with a financial professional who can help guide decisions about asset allocation and investment selection.
Sources
- Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing. https://www.investor.gov/additional-resources/general-resources/publications-research/info-sheets/beginners-guide-asset.
- What is diversification? https://www.investor.gov/additional-resources/information/youth/teachers-classroom-resources/what-diversification.
