What is asset allocation?
Asset allocation refers to the strategy of dividing your investments among different asset categories, such as stocks, bonds, real estate, cash, and cash alternatives. Asset allocation aims to control risk by diversifying an investment portfolio.
The purpose of asset allocation is to maximize returns and minimize risk. While there are no guarantees that any particular mixture of investments will be more profitable or less risky than any other, a solid diversification strategy helps optimize a portfolio of investments.
Whereas asset allocation describes the proportion of a given portfolio held in different sorts of assets, diversifying and rebalancing comprise the act of allocating assets.
Investors diversify their portfolio by holding a portion in stocks and a portion in bonds, which helps balance risk. During market downturns, stocks suffer and bonds thrive; in a bull market, stocks appreciate and bonds lose value. Keeping a portion of the portfolio in cash is always a good option.
Rebalancing means changing the proportion of different assets in a portfolio. Asset allocations can fall out of alignment as investors change their outlook and the economy changes. Rebalancing tunes the allocation of assets in a portfolio to a more appropriate level of risk. Professional investors are constantly looking to rebalance their portfolios, while individuals rebalance less frequently.
Risk tolerance measures the degree of uncertainty an investor is willing to accept in exchange for greater or lesser future gains. More risk tolerant investors are willing to absorb more near-term losses for potentially greater returns in the future. Risk tolerance is also determined in part by how much you have to invest; a greater total amount of capital means an investor can absorb more losses over time.
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Asset allocation example
A conservative asset allocation would put 70 percent to 80 percent of available capital in bonds, 15 percent to 20 percent in stocks, and the remaining portion in cash or cash equivalents. Alternatively, an aggressive asset allocation would place up to 70 percent of available capital in equities, 20 percent to 25 percent in fixed income, and the balance in cash.