The Basics – Understanding Asset Allocation

Every investment strategy has the same basic goal – to make money grow. Given the inherent risks associated with investing, this is easier said than done. There are many factors beyond an investor’s control – a struggling economy, market volatility, changes in interest rates, global conflicts, etc. – that can impede, or even halt, investment growth.

Smart investors counter this external static by keeping it simple. They don’t chase the hot investment of the moment. They don’t try to guess what the markets are going to do next. They use an approach called “asset allocation.”

Investment Asset Classes

Asset allocation is simply dividing the money you invest among different asset classes. There are three primary asset classes – stocks, bonds and cash.

• Stocks: U.S. stocks are ownership shares in a company. Historically, stocks have offered the best opportunity to grow the value of an investment over the long term. However, they also pose the greatest risk of losing money, especially over the short term, due to the cyclical ups and downs of the stock market.

• Bonds: Bonds are essentially loans to companies or government entities that are paid back over time with interest. They offer greater stability and less investment risk than stocks and may produce a steady stream of income, even in a down economy. The trade off for this stability is a more modest growth rate than what is possible with stocks.

• Cash: Cash and cash equivalents are the safest investments. They include savings accounts, certificates of deposit (CDs), U.S. Treasury bills and money market accounts. While these investments will likely maintain their value, regardless of market conditions, they offer the lowest growth potential to investors.

Helps Protect Against Losses

Asset allocation can help protect your investment portfolio against overall investment risk. That’s because asset classes don’t all react the same way to changing market conditions. For example, a falling equity market may hurt your stock investments, making bonds the better return on investment in times of uncertainty.

So investing in multiple asset classes allows you to hedge against a loss in any single class. If one asset class goes in the tank for a period of time, the potential of better returns on the other classes may help limit losses to your overall portfolio.

Clearly, the more you diversify across asset classes the better the chances of attaining your financial goals. For the best results, diversification should also apply within asset classes. This is especially true when it comes to stock investments, which should be spread over a variety of companies – large to small – as well as a variety of market sectors.

One Size Does Not Fit All

The allocation mix that will work best for you is highly personal. In general, once you’ve defined your investment objectives, it depends on two factors:

• Your time horizon – The number of years you have to invest in pursuit of achieving your financial goals.
• Your risk tolerance – The level of risk you are willing to assume to increase your chances of greater returns.

Young investors with a long time horizon might initially allocate a majority of their assets to stocks. Although they are the riskiest investment, stocks offer the greatest potential for long-term gain. And when you have time on your side, you may want to wait out market downturns. As your time horizon shrinks, adjust your asset allocation as conditions dictate.

If you have some short-term financial goals, such as paying for college, you might want to be more conservative from the get-go and have a greater proportion of bonds in your asset allocation mix.

Whatever mix you choose, asset allocation is critically important to your financial well being. Get it right by working closely with a qualified advisor.

Diversification and asset allocation do not assure or guarantee better performance and cannot eliminate the risk of investment loss.

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