There’s an old saying that you shouldn’t “put all of your eggs in one basket.” This saying might not have originally been about investing, but it’s the perfect way to describe the importance of asset allocation to your investing strategy.
Asset allocation is a fancy-sounding term that refers to a relatively simple concept: spreading your investment money out among the three primary asset classes of stocks, bonds (or fixed-income instruments) and cash equivalents, like savings and money market accounts.
Reducing Risk and Volatility
The idea behind asset allocation is to reduce portfolio risk and volatility by not putting all of your investment assets (or eggs) into a single type of asset class (or basket). Doing so can expose you to significant risk if the asset class in which you’ve placed all or most of your investments falls in value precipitously.
One of the best examples of this danger is the bursting of the dot-come bubble in the early 2000s. Excitement over new Internet companies and stocks led to a boom in technology stocks in the late 1990s — the Nasdaq Composite Index soared from 1,663 in September of 1998 to 5,048 in March of 2000. But when the bubble burst, the Nasdaq quickly reversed course, plummeting to 1,114 less than three years after hitting its 2000 peak.
Individuals who excitedly invested all of their assets in technology and dot-com stocks were delirious as the Nasdaq nearly tripled in value during 1998 and 1999. But when it came crashing back down to earth over the next couple of years, many lost their life savings or had to delay retirement due to the damage the Nasdaq crash caused to their portfolios.
3 Questions to Ask
To choose the right asset allocation for you and your family, you need to answer a few key questions:
- What are my main investing goals?
- What is my investing time horizon?
- What is my level of risk tolerance?
Two common investing goals are saving for children’s college educations and saving for retirement. Both of these are usually long-term goals with a time horizon of 10 years or longer, assuming you haven’t waited too long to get started. Therefore, you might be willing to adopt a more aggressive asset allocation strategy that assumes more risk since you have more time to make up potential short-term losses.
For example, if you are in your 30s and investing for retirement, you may have a 30-year investing timeframe until you’re ready to retire. So you could possibly choose a fairly aggressive asset allocation mix of 60 percent stocks, 30 percent bonds and 10 percent cash. But if you’re in your 50s, your investing timeframe is much shorter and you have less time to recoup potential short-term losses. In this case, you might prefer to adopt a more conservative asset allocation mix of 30 percent stocks, 30 percent bonds and 40 percent cash.
Risk tolerance also plays a role in asset allocation. If watching the daily gyrations of the stock market makes you nervous and causes sleepless nights, you might prefer to choose a more conservative asset allocation strategy regardless of your time horizon.
Next-Level Asset Allocation
The next step in asset allocation is to further divide your assets among different types of stocks and bonds. For example, there is a wide range of different classes of equities based on the many different types of companies that issue stock for sale to the public. Large-, mid- and small-cap; international; emerging market; income; growth; value; and technology are just a few examples of the different classes of stock you can purchase.
So you need to decide more than just what percentage of your assets should be invested in stocks, bonds and cash. You also need to determine how you will allocate the stock portion of your portfolio among the different classes of stock.
Asset allocation is a very individualized process — it will be different for every investor. Your investment advisor will work with you to help you determine your investment goals, risk tolerance and investing timeline. Then you can decide on the right asset allocation strategy for you.