What Is Asset Allocation And Why Does It Matter?

If you’re reading this article, you’re probably wondering what steps you can take to increase your chances of achieving financial wellness. Asset allocation is a crucial consideration for anyone saving and investing their money. This form of investment management involves spreading your stakes across different types of assets in order to minimize risk and maximize returns. By diversifying your portfolio, you can reduce the impact of market fluctuations and better increase your chances of reaching your investment goals. Let’s take a look at what asset allocation is, different asset classes, and things to consider before taking on this investment strategy.

How Asset Allocation Works And Why It’s Important

Asset allocation is an investment strategy that divides investments among different asset types to diversify an investor’s portfolio. The investor may adjust the percentage of each investment type according to market conditions.

In simple terms, asset allocation means you do not put all your eggs in one basket. Instead, you diversify your portfolio by investing in multiple virtues. By doing so, you protect yourself from losing everything in the case that market conditions fluctuate. For instance, instead of investing every penny you save in ETFs, you might consider putting some cash into real estate or high APR savings accounts as well. That way, if the ETF market ever takes a major hit, you’d still have growing assets in other classes.  

Key Asset Classes For A Diversified Portfolio

Each asset class has its own risk tolerance and return profile, which makes them suitable for different investment goals and objectives. By allocating your investments across multiple asset classes, you can create a balanced portfolio that can withstand market volatility and generate consistent returns over time.

The four major asset classes are:

Stocks

Stocks, also known as equities, represent ownership in publicly traded companies. Investing in this asset offers the potential for high returns, but it also comes with a higher level of risk. The stock market can be volatile, and the value of individual stocks can fluctuate significantly. However, over the long term, stocks have historically outperformed other asset classes, making them an essential component of a well-diversified investment portfolio. Generally, financial advisors would suggest having a mix of stocks rather than investing everything into an individual company.

Bonds

Bonds are debt securities issued by governments, municipalities and corporations. In fact, things like mortgages and treasury bills are exchanged on the bond market. There are several bond types, but essentially what happens when you invest in this asset is that you lend money to the issuer in exchange for periodic interest payments and the return of the principal amount. Bonds are generally considered less risky than stocks and provide a steady stream of income, making them an excellent choice for conservative investors looking for stable returns and income generation.

Cash

This may seem counterintuitive, but having cash equivalents in your portfolio can absolutely compound and grow over time. Savings accounts, certificates of deposit and money market funds are all examples of highly liquid assets that are easily convertible into cash. Cash is the most liquid asset class, but it generally offers the lowest potential returns because of rapidly increasing inflation rates. However, having a portion of your portfolio allocated to cash can provide stability and serve as a buffer during market downturns.

Real Estate

Real estate is a popular asset class for diversification as it has a low correlation with stocks and bonds. However, it requires a significant upfront investment and may have higher transaction costs.

Diversification Vs. Asset Allocation

The goal of diversification is to avoid putting all of your funds into a single investment. For example, say you invest in a single stock from a single company. One way to diversify would be to buy additional stocks from multiple companies of varying risk. This would minimize the overall risk because if one stock declines in value, other investments can make up for it. Asset allocation, on the other hand, is an avenue to diversification because the strategy is not only to simply have multiple investments, but to have different types of assets within the investments as well.

Common Models For Allocation Of Funds

There are a number of asset allocation strategies that can be used to benefit your specific goals. A few of these strategies include:

Tactical Asset Allocation

Tactical asset allocation is an active approach to asset allocation that involves shifting the percentage of allocation based on unusual market conditions or strong opportunities. This strategy focuses on the short-term, so it provides a lot of flexibility, but may not be sustainable for those looking for a more passive long-term approach.

Strategic Asset Allocation

Strategic asset allocation is considered a more “hands-off” approach to asset allocation. The allocation is set based on your risk tolerance, and the portfolio is simply rebalanced periodically. This strategy is seen as best for new investors investing for the long-term.

Insured Asset Allocation

Insured asset allocation is a strategy in which you actively manage your portfolio to increase its value, and invest in risk-free assets should that value begin to drop. Insured asset allocation is a great strategy for financially-savvy but risk-averse investors, as it requires active management of your portfolio, but ensures those funds don’t dramatically decline.

Factors To Consider Before Allocating Your Assets

Before allocating (or reallocating) your assets, it’s important to look at your personal factors to assess how best to go about it. Some factors you’ll want to consider include are your:

Age

Your age can determine what money goals you’re after, and therefore how proactive and aggressive you should be with your investments. For example, if you’re nearing retirement age and looking to use your investments to fund your retirement, a less risky investment that safeguards your current portfolio may be more beneficial to you. However, if you’re younger and looking to keep your investments long-term, a riskier portfolio might be in your favor. That’s why it’s so important to consider your short and long-term goals.

Risk Tolerance

Your risk tolerance may be influenced by your age and money goals but should still be looked at separately. If your money goals and age lend for a riskier investment, but you’re unwilling to take drastic measures, a more conservative approach may be the best choice for you.

Existing Assets

You may already have an investment in multiple assets through a mutual fund. However, taking a close look into each investment and doing market research will prove beneficial. Even if no assets are sold or added, your decision for how to allocate them may change.

Goals

Money goals can include anything from retirement plans to buying a house. Your money goals can inform the assets you want to invest in. For example, a 401(k) is often used for retirement and may even have an opportunity for matching contributions from your employer.

How To Rebalance Your Investment Portfolio

Rebalancing your investment portfolio is crucial for maintaining your desired asset allocation. Over time, the performance of different asset classes can vary, causing your portfolio to deviate from its original allocation. For example, if the stock market experiences a significant increase in value, your portfolio may become overweight in stocks. In order to rebalance your portfolio, you would sell some of your stocks so that the scales are balanced. On the other hand, rebalancing also allows you to take advantage of market opportunities when certain asset classes become undervalued, allowing you to purchase new assets for your portfolio. You should watch your portfolio and rebalance whenever it seems necessary so that you ensure it remains within aligned with your desired asset allocation limits.  

Asset Allocation FAQs

Still have questions about asset allocation? A couple commonly asked are:

What is an example of asset allocation?

There are three types of asset allocation methods: strategic, tactical and insured.

What are the four major asset types?

Stocks, bonds, cash and real estate are the four major asset classes.

The Bottom Line: Asset Allocation Is A Common Strategy For Better Investment Returns

Asset allocation is an investment strategy where funds are divided and strategically diversified. There are several types of assets for you to consider, as well as several specific strategies and considerations to think about before moving forward. Deciding to diversify your financial portfolio can be difficult, so it’s important you consult a financial advisor before making any big decisions.

If you’re ready to take the first steps toward allocating your assets, you should consider downloading the Rocket Money℠ app today. In this personalized app, you can see all your financial information in one place – giving you a clearer picture of the state of your finances.