Asset Allocation

Asset allocation is an investment strategy used to distribute funds among different asset classes like stocks, bonds, and real estate. Asset allocation is based on the fundamental principles of diversification, balancing risk and reward, and recognizing that different asset classes come with different risks and reward levels.

For example, US Treasury bonds are a very safe investment, but compared to stocks on average they pay a low return. So investors with a more conservative outlook-that is looking to preserve their capital rather than grow it aggressively-may look to have a large share, even a majority share of their investments in US Treasury bonds, or similar vehicles like municipal bonds.

On the other extreme, a more aggressive investor who wants to grow their capital rapidly and can live with a large amount of volatility, may devote a large share of their investments to stocks. On average the US stock market has a return of around 12% per year, higher than any bank account or CD and even higher than most bonds. Try emerging stock markets and you're looking at even greater returns. The trade-off, however, is increased risk-stock markets collapse from time to time and take investors money with it.

The way that you divide up your investment funds is essentialy what asset allocation is about. So conservative investor A may put 65% of her money in US Treasury bonds, 5% in the bank and the rest on stocks, while wild Willie will put 75% of his money in the stock market, 20% in high yield bonds, and 5% in currency trading. Hapless Harry who doesn't think about asset allocation put his entire life savings in Xerox, and was disappointed when the stock price plummeted to $7 a share.

Asset classes, which are places you can invest your money, can be divided into stocks, bonds, currency trading, precious metals, commodities (oil, gas, corn, lumber), and real estate.

Furthermore, within a given asset class there may be further divisions among risk and reward. For instance consider stocks. These can be grouped by region with varying risk (U.S., Japan, China, Brazil), by company size (small-cap, mid-cap, large-cap), or by style (value, growth, or blend).

If you are an aggressive investor, your asset allocation may be heavily weighted not only to stocks, but to growth stocks and emerging markets. A more risk averse investor may stick to large-cap value or blend stocks.

In bonds, more aggressive investors may seek out "junk bonds", while those more interested in preserving their capital would gravitate more toward municipal bonds, say. Someone wanting some balance may mix up their bond investments.

In short, the asset allocation strategy you use depends on how much risk you're willing to assume and what your financial goals are. Asset allocation also helps you spread your risk by building a diversified portfolio.

Putting too much money in high growth investments can be risky-you can even risk losing all of your money. On the other hand, simply sitting on your cash, say stuffed in a mattress, isn't going to help you grow your investments. What smart investors need is a balance between the two approaches.

In his book "Discover the wealth within" financial advisor Ric Edelman gives an excellent example. Investor A takes $25,000 and puts it all into a bank CD paying 5%. In 25 years, A has $84,659.

Learn more about asset allocation and other financial tips in Ric's Book

Investor B, on the other hand, breaks up her $25,000 into $5,000 blocks. She blows $5,000 on lottery tickets. Then she simply stuffs another $5,000 in her mattress. Among the rest, she puts $5,000 in an ordinary savings account paying 2%, puts $5,000 in US government bonds paying 5% per year, and then puts $5,000 in stocks. At the end of 25 years, B has $115,135.

So, a different asset allocation will produce different results. Consider that of the $115,135 that B earned, $85,000 of it came from her investment of $5,000 in stocks. That's the same amount as A got for the entire investment in a bank CD. What if instead, B had put $7,500 in stocks and just $2,500 in US Treasury bonds?

In that case, B would end up with $127,500 at the end of the 25 years- just from stocks! Her entire investment would have grown to $149,000.

This illustrates the powerful effects different asset allocations can have. In fact, B could have grown her money even more by taking some of that cash in her mattress and putting it in the stock market. But the lesson here is not to put everything in stocks, doing so is risky. If you have a long time frame within which to invest, you can put more in stocks because you can wait it out when that inevitable stock market crash comes calling. If you're closer to retirement, a market crash could wipe you out at the wrong time, just when you need your money. So you'd be better off putting more money in bonds and bank investments like CDs and money market accounts to make sure its there when you need it.

So your age, goals, and ability to tolerate risk are all factors in determining your asset allocation.

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