What is Asset Allocation & Diversification and how does it fit into investing in stock market?
What is Asset Allocation?
It is arguably one of the most important concepts you can understand when it comes to investing your money in equities, bonds, and cash in the stock market, and how it relates to your overall net worth. Asset allocation is essentially the recipe used to make your investment pie. The recipe and proportion of ingredients (equities, bonds, cash) you use will determine the type of the pie you make. These ingredients, also known as asset categories typically include equities, bonds, and cash, and can be mixed in a variety of ways to end up with a particular allocation.
So how do you determine how much of your money should be in equities, bonds, and cash?
Questions to ask yourself when determining your asset allocation:
- What is your time horizon? How many years till you need this money?
- What is your risk tolerance? How much volatility, ups and downs in your account value, can you stomach highs and lows of the stock market?
- What type of money (account) are you working with? Is it a 401k or IRA retirement account, or is it money you need for your child's education next year?
- What it is you hope to achieve using your investment dollars – improve current lifestyle; achieve capital growth; fund a specific goal, such as a college education
There are no wrong answers to these questions. They are personal and based upon your current financial and life situation. Once you have answered these questions you are ready to figure our what mix of assets could be appropriate for you and your money.
No Pain, No Gain (No Risk, No Reward)
This statement can be used in almost all aspects of our lives. It holds particular credence when it comes to your money and investing equities, bonds, and cash in the stock market. Investing involves risk. The more risk you are willing to take the better probability you have of making a higher return on your money, usually over the long term. If you need your money in six months and don't like investing in the stock market then you shouldn't expect to make very much.
For example, let's say you have an old 401k or IRA retirement account.
- You are 40 years old.
- Chances are that unless you have a major life emergency you probably won't need this money for 20 years or longer.
- You may not understand the inner workings of the stock market but are still comfortable being invested.
In other words you have a long time horizon and at least a moderate appetite for risk. Knowing this one could argue that you would allocate more of your money to equities, while still having some in bonds and cash. This mix could be called a 60/40. What is 60/40? 60 refers to the percentage of your money that is invested in equities. 40 refers to the percentage of your money that is in bonds & cash. Having a higher percentage of your money in equities has historically led to a higher rate of return over longer market cycles, yet there would be more bumps (risk) along the way. This is an simplified example, but demonstrates how asset allocation works.
Another way to think of it is to compare the risk/reward trade off like that of a rollercoaster ride. A low risk asset allocation would be like a slower rollercoaster that has very few dips and climbs. A high risk asset allocation would be like a faster rollercoaster with bigger dips but also much higher highs. Different styles for different people.
The impact of asset allocation on returns depends on your investing style. For the long-term, passive investor, the asset allocation decision is by far the most important. For the short-term investor who trades more frequently, invests in individual securities, and practices market timing, asset allocation has less of an impact on returns. The impact of asset allocation on performance is directly correlated with investment style.
Individual Asset Allocation Strategy
When done properly, your allocation of assets will reflect your desired goals, priorities, investment preferences and tolerance for risk. Asset allocation is an individualized strategy, so there really is no perfect mix of equities, bonds, and cash assets. Your strategy should be built on the careful consideration of the key elements, listed above, of your financial situation.
An Evolving Strategy for your Asset Allocation
A sound asset allocation strategy includes periodic reviews of your mix of equities, bonds, and cash.
About the only certainty when it comes to the financial markets is that they will change, and so will your financial situation. Through market gains and losses, a portfolio can become unbalanced and it may be important to make adjustments to your allocation. As you move through life’s stages your needs, preferences, priorities and risk tolerance will change and so too must your asset allocation strategy.
Asset allocation should not be confused with the concept of diversification. Diversification basically is the spreading of your money within the different asset categories you have for your asset allocation. Using the example from above, within the 60% of your portfolio that is in equities, that amount could further be diversified among those equities in the United States and internationally, as well as different size and sectors of companies in these regions. The same would can be assumed for your bond & cash portion.
It has been our experience that figuring out your asset allocation is best done by first answering the questions above and then either using online tools or working with a qualified adviser who can help you make sense of it all. Regardless of how you do it, just taking charge of your asset allocation can have a huge impact on your overall financial situation.