What Is Asset Allocation, And Why Should I Care About It?

It’s kind of like this. Sorta.

Asset allocation is an essential component of successful investing, yet it's often overlooked - even by the most experienced investors. Asset allocation is the process of dividing your investments among different asset classes, such as stocks, bonds, cash, and alternatives in a way that matches your investment goals, time horizon, and appetite or willingness to take risk. A well-diversified investment portfolio can weather different market conditions, reduce the risk of investing in only a handful of companies, and deliver returns over time that allow you to meet your goals.

To break down the importance of asset allocation, let’s consider building a house. Before you get started, you need a blueprint and schematics, and then you need to decide on the right materials to use. You want to make sure your house can withstand different weather conditions, such as rain, wind, and snow – and depending upon your personal circumstances, even more extreme conditions such as hurricanes, tornadoes and earthquakes.

Like you need the right materials to withstand the right weather conditions, you need to choose the right investments to create a diversified portfolio that can withstand different market conditions. Just as you wouldn't build a house with only one type of material, you wouldn't invest all your money in one type of asset, such as stocks. Instead, you would choose a mix of stocks, bonds, and cash that match your investment goals and risk tolerance.

if you have a long-term investment horizon and can tolerate more risk, you might allocate a higher percentage of your portfolio to stocks. You’re comfortable with the volatility that comes with knowing that it meets your objectives. On the other hand, if you have a shorter investment horizon, or you want to minimize risk, you may allocate more to bonds or cash. The point is that a diversified portfolio with a balanced asset allocation is essential for long-term investing success.

Don’t like the house metaphor? Let’s consider cooking. You’re hosting a dinner party and want to create a meal that will impress your guests and leave them satisfied. What’s on the menu? Boiled chicken breast with salt and pepper? No thanks. When it comes to entertaining, variety reduces risk of only catering to certain tastes or disappointing guests with a bland meal. So, you’d create a menu that includes a variety of foods, such as a salad, a soup, and maybe some type of meat dish with a great combination of seasonings.

If you want to generate income from your investments, you may allocate a higher percentage of your portfolio to bonds or dividend-paying stocks. If you want to grow your investments, you may allocate more to growth stocks or mutual funds. Maybe a little bit of both is your goal – that’s okay too. Spice it up by adding both types of funds to your portfolio.

Bon Appetit!

Disclosure: Investing involves risk, including the potential loss of principal. The information provided in this blog post is for educational and informational purposes only and should not be construed as professional financial advice. Consult with your financial professional before acting on any information discussed in this article and consider all taxes, fees and expenses.