While you may understand that diversification involves investing across different industries and businesses (see Industries vs. Sectors: What's the Difference?), you might not realize how important it is to look at your investment portfolio in terms of asset class as well.
Asset allocation is a major strategy used by fund managers (see
portfolio manager) to meet the investment goals of fund investors. Basically, managers look at how the value of a portfolio of investments is divided among the three main asset classes (equity, fixed-income and cash). So how can you use that strategy in your own portfolio?
Aim, Then Allocate
With asset allocation, it's all about goal-oriented investing. Whose goal?
Since each asset class has different characteristics, the way you split your portfolio between equity, fixed income and cash can have a direct effect on whether or not you'll be able to finance your goal.
So the first criterion for determining whether asset allocation should be put to use in your personal portfolio is your end goal. For example, if you're a
"So You Want to Daytrade"), you're probably going to have very different goals from someone who's primarily investing for retirement (see
IRA-related stories on TheStreet.com
). For individual investors, asset allocation can really help those who are investing for a high-cost, long-term goal such as retirement or a college fund.
Three Classes for the Long Road
There are three main asset classes: equity (stocks), fixed-income (bonds) and cash (money markets). The markets for each of these behave very differently from one another, so here's a look at each one:
: This asset class includes individual stocks and stock funds. This is the most
volatile (or "risky") of the three classes, so portfolios with higher proportions of equities are more prone to fluctuations in value than they would be if they were made up mainly of the other two classes. With this risk, however, comes the greatest historical return on investment. (If you need help handling the ups and downs of this asset class, check out the
"Stock Doc" Column
: For our purposes here, fixed-income investments are more commonly known as bonds. While not as volatile as equities, bonds don't historically offer the same gains as the stock market does. (To learn more about bonds, check out
"Getting Started With Bonds".)
Cash (and equivalents)
: This is the least volatile of the asset classes. This class is (quite literally) money in the bank.
Money markets, certificates of deposit (
CDs) and the like are the short-term investment funds that comprise cash.
While there are some special types of assets that can span a couple of classes at the same time (for example, cumulative preferred stock), most beginning investors' assets will typically fall into one of the three main classes. (Other asset types to be covered in the future include derivatives, precious metals and real estate.)
Manage Risk, Reach Your Goal
With asset allocation, your goal is to decrease the risk in your portfolio as you approach your goal. For example, as an eventual retiree, you want to slowly decrease your retirement account's volatility as you approach the day that you you'd like to actually retire -- locking in the gains that you've already made on riskier investments.
In other words, the golden rule of asset allocation is that when you've got more time until your goal, you can afford to have more risk (such as equities) in your portfolio. Since the stock market has historically made money over time, you're less likely to be adversely affected by a negative downturn if you've got the time to ride it out.
As a new member of the workforce, it's not really that crazy to have a retirement account that's entirely made up of stocks. If you're 58, however, and you're starting to seriously consider retiring, you might want an asset allocation weighted more toward lower-risk investments such as bonds.
That doesn't mean that you should convert to 100% cash by the time you reach your goal-time (whatever and whenever it happens to be). You've also got to consider your drawdown horizon -- the time over which you expect to take the money out. For instance, if you're saving for your kids' college fund, you're probably looking at a drawdown horizon of four years. Those are four years when your money -- or at least part of it -- can still grow.
Building Your Portfolio
Now that you understand the biggest part of asset allocation -- how your portfolio should be weighted as you approach your investment goal -- it's time to think about how to build that portfolio.
When you're picking specific stocks, bonds, or funds for your portfolio, consider how long you might want to actually hold each investment as well. Consider this three-grade approach to building your portfolio:
1. Primary core holdings
: These are the significant positions you hold in your portfolio.
Blue-chip stocks and
investment-grade bonds are examples of potential primary core holdings. They're investments you would consider holding for the long term.
2. Secondary core holdings
: These positions are more volatile than the primary core holdings. These investments augment your long-term positions. Such investments could include
mid-cap stocks or funds as well as overseas stocks or bonds (see
"How Do I Invest Overseas?").
3. Non-core holdings
: Investments like these can round out your portfolio, by including more sector-specific investments, such as index funds or focused funds (see
"Index Funds" and
In keeping with the principles of asset allocation, consider putting the majority of your equity and fixed-income investments in primary-core holdings, with secondary-core and non-core holdings there to add a little risk.
Too Hands-On for You?
If using asset allocation to reduce the risk in your portfolio still seems too hands-on, you can still have a robust portfolio without having to pay for a financial adviser. Lots of investment companies offer something known as a pre-constructed fund (or
target-date fund), which is essentially a constructed, asset-allocated mutual fund. Pre-constructed funds are designed for a specific target year, so make sure to choose wisely if you decide to go this route (see
"When Target-Date Funds Miss the Mark").
Examples of pre-constructed funds are the
Fidelity Freedom 2030 Fund
, a fund with a moderate asset allocation, as well as the
Vanguard Target Retirement 2050 Fund
, which is more heavily weighted toward equities right now. Even if you don't believe you want to go with a pre-constructed fund, looking at the asset allocations of funds like these can be great reference homework on its own.
It's Allocation Time
Whether or not retirement is looming on the horizon, it's essential to "construct" your portfolio the right way from day one. By understanding the concepts of asset allocation used by the pros, you can make your portfolio grow for the long haul and ultimately get you to wherever it is you want to go.
To learn more about asset allocation and portfolio management, check out these stories on
- Three Elements for a Benchmark Portfolio
- All Investors Need a Game Plan to Play the Market Right
- Investing Pros: Workers Need More Guidance
- Follow Three Steps to Financial Health
Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.