About Asset Allocation

You may not need to be an expert to manage your investment portfolio. Just showing initiative—as you’re doing to learn more about investing—is an important step. As you’ll see, certain investing strategies may help you weather market cycles and pursue your savings goals: asset allocation, diversification, rebalancing and reallocating.

Asset allocation is a fancy name for a simple strategy. It means spreading investments across the different asset classes we’ve covered: stocks and stock funds, bonds and bond funds, and cash equivalents. When you choose your asset allocation, you allocate a certain percentage of your money to each of the asset classes.

A suitable asset allocation depends on 3 major factors:

  1. Your goals. What are you saving for? How much money do you want to save?
  2. Your timeline. When will you need the money? People who are within a few years of retirement, for example, may want to invest conservatively. That means less money in stocks and more in bonds and cash equivalents. If you have decades until you need the money, you may want to consider investing aggressively, with more money in stocks. 
  3. Your risk tolerance. Your strategy for investing may change over your lifetime, based on your age and financial circumstances. For example, investors who can ignore temporary market dips might be able to tolerate the higher risk of stocks. 

Sample Asset Allocation Models

Here are simple examples of asset allocation models showing the percentage of assets in sample portfolios. These models are for illustration only and are not meant to represent actual asset allocation from financial advisors to investors.

A Dive Into Diversification

Diversification takes the strategy of asset allocation one step further. With diversification, you buy different assets within a particular asset class. 

Why Diversify?

It’s easy to see that putting your faith in just one investment means your entire portfolio is dependent on its ups and downs.

For example, suppose you buy 100 shares of hypothetical XYZ Company at $10 a share, for a total of $1,000. XYZ Company invents a new gadget. Its stock rises to $30 a share. You’ve just tripled your money. What if, instead, another company comes up with a better gadget and your stock in XYZ Company drops to $5 a share? You’ve just lost half your money. Ouch.

On the other hand, if you spread that original $1,000 investment among 5 different companies, then the stock prices are not likely to all go up and down at the same time. You might not make as much as you could with one superstar stock, but you also may not lose as much as you could with one failing company. It’s all about seeking growth while spreading the risk.

Think of diversification as broadening your horizons, only with your money instead of your talents.

Diversifying Your Stocks

Besides simply choosing different companies, other ways to diversify include the following:

By market capitalization. Market capitalization (cap) is the value of the company represented by the number of shares outstanding times the market price of each share. You could choose among large-cap, mid-cap, small-cap and micro-cap stocks. Multi-billion dollar companies like Apple and Microsoft are examples of large-cap stocks. Generally, large-cap stocks are the most conservative. Small- and micro-cap stocks are more aggressive, particularly start-up operations, and mid-caps are in-between.

By geography. You could choose foreign stocks in addition to domestic (U.S.) stocks. Keep in mind that foreign investing involves additional risks, such as currency fluctuations, government overthrow and different accounting standards than the U.S.

By sector. Consider choosing companies among different industries, such as energy, transportation and health care.

Diversifying Bonds

Here are a couple of ways to diversify bond holdings:

By maturity. You could choose to hold anything from long-term (10- to 30-year terms) to short-term (generally, 1- to 3½-year terms) bonds. Longer-term bonds may pose more interest-rate risk (the chance that interest rates may go up and the price of the bond goes down). Short-term bonds may pay less interest. Bond rates are largely dependent on the term plus the credit rating of the bond.

By issuer. Choose from bonds issued by corporations, municipalities and the federal government. U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, and therefore are considered the least risky.

Rules for Rebalancing and Reallocating

Rebalancing is a simple concept. It’s the process of adjusting an asset allocation that may be out of whack due to investment performance.

You may want to rebalance your portfolio once a year or whenever your asset allocation strays significantly from your target.

A slightly different approach is called reallocation. Rather than buy and sell to return to your original target allocation, you buy and sell to create a new target asset allocation. For example, perhaps you’ve realized that, with 30 or more years until retirement, you can afford to take more risk with your investments. Right now, your portfolio consists of: 60 percent stocks, 30 percent bonds, 10 percent cash equivalents. Reallocation to a new, more aggressive asset allocation target would involve selling bonds and cash equivalents and buying more stocks.

Conversely, you may think your portfolio is too aggressive because you’re reaching a savings goal and want to focus on protecting your money. In that case, you’d sell stocks and buy more bonds and cash equivalents. The idea is to maintain an asset allocation that's appropriate for your goals, timeline and risk tolerance.  

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