Retirement Basics: Advantages of Asset Allocation
When it comes to investing, there’s a lot of terminology and jargon you might see bandied about by financial professionals or the media. Most of these terms are not hard to understand – but they may seem baffling at first glance.
Understanding some basic investing terms is helpful because it can help transform investing from some arcane art into a simple process. And the more you see investing as a process based on rules and logic, rather than something based on emotions, the more likely you will find success.
One important term every investor should understand is asset allocation. Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon. Investors may use different asset allocations for different objectives.
Improper asset allocation is one of the most common mistakes an investor can make. Why is asset allocation so important? Look at it this way: If you were to eat only one food every day for your entire life, your body would be very unhealthy. If you were to exercise only one group of muscles for your entire life, your body as a whole would be very weak. And when you invest all your money in the same way, the same could be true of your finances.
Asset allocation is basically a strategy that spreads your investments across different “asset classes.” The three main classes are equities (stocks), fixed income (bonds), and cash. There are other classes, of course, like commodities and real estate. And there are sub-classes as well. For example, “stocks” can be divided up into many different classes, like international stocks, small, mid, and large-cap stocks, etc. The thinking behind asset allocation is that by mixing your investments within these different classes, you take on less risk. That’s because if one class goes down in value, the other classes you’ve invested in can compensate.
Here’s an example of why asset allocation is so important. Let’s say that in Year 1, the stock market goes through the roof. So you put all your money into stocks. But in Year 2, the stock market performs poorly. It’s possible you could end up losing a lot of money. Now let’s say that instead of putting all of your money into stocks, you put 50% into the bond market. When the stock market went down, investors started pouring their money into bonds, causing bond prices to go up. That means that even though your stock holdings decreased in value, your bond holdings increased, meaning you could still break even or possibly come out ahead.
Of course, this is a very general, very simplified example. I’m certainly not recommending you do anything like that. There is no simple formula that can find the right asset allocation for every individual. But hopefully, this illustrates the point: Putting all your eggs in one basket is rarely a good idea.