What is asset allocation and how does it work?

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Asset allocation is how your assets are divided among various asset classes to reduce risk and potentially increase your returns. Each type of asset – stocks, bonds, and even cash – performs differently over time, and smart asset allocation involves creating a portfolio that optimizes your long-term return and minimizes your risks while you achieve it.

Smart investors use asset allocation to create a portfolio that meets their financial needs and temperament – factoring in their risk tolerance, time horizon, and need for investment returns.

Here’s what you need to know about asset allocation and how it can benefit you.

How asset allocation works

Asset allocation depends on asset classes having different traits. Each asset class may perform differently when an economy moves in a given direction. As the economy grows, some assets move up, while others may stay flat or even go down, depending on the specific circumstances.

This quality of being non-correlated allows investors to build portfolios that zig when the market zags. By mixing and matching the qualities of the asset classes, an investor or financial adviser can make a portfolio less volatile and potentially achieve the same returns as or better than a riskier portfolio. Asset allocation takes advantage of the principle of diversification to reduce risk.

For instance, if you have 30 years until retirement, you can afford to take more risk in exchange for the higher potential returns available in the stock market. So a financial adviser or robo-adviser would usually recommend a higher allocation toward stocks and less in low-return bonds.

However, as you near retirement an adviser might gradually shift you into safer assets, such as more CDs or bonds. CDs offer guaranteed returns, a valuable trait when you need low risk.

What are the important asset classes?

Below are some key asset classes and some general traits of each:

Asset class Characteristics
Stocks High risk, high return. Stocks can return the most over time, but will fluctuate the most along the way. Some stocks are less risky than others, such as dividend stocks. Stocks tend to do well in a growing economy and poorly in a weak one.
Bonds Bonds pay regular interest income and tend to be relatively stable. Bonds are usually much safer than stocks, though the performance of the bond depends a lot on the quality of the issuer (government, corporation, or others).
Real estate Real estate comes in many forms, and you can make money on price appreciation as well as income. Physically owning real estate can have a different risk-return profile than buying it through a real estate investment trust on the stock market, and may include a lot more work, too. Real estate tends to appreciate slowly over time while throwing off cash.
Cash Cash is the most stable asset of all, but it receives very low returns and loses value to inflation over time. However, it’s immensely important in a downturn, because it can float you through an emergency and may be invested in assets that have declined in value. A high-yield account can max its value.
Gold Gold is a popular investment that often does well when the economy gets into trouble or when other assets are doing poorly. Many investors use gold as a hedge or a store of value, especially when they think inflation may pick up due to the government printing more money.
Alternative assets Alternative assets include private equity funds, obscure precious metals, farmland, art and whatever else investors think might not be correlated to the broader markets. Non-correlation is  often key to what is categorized as an alternative asset.

More recently, some investors have been turning to bitcoin and other cryptocurrencies as a way to get other non-correlated assets into a portfolio. However, some investors, including investing legend Warren Buffett, think such investments are little more than junk.

How do you use asset allocation?

You can use asset allocation in many different ways, and you may already be using it without thinking much about it. For example, if you own your own home and invest in the stock market, you’re already using asset allocation, even if you’re not taking maximum advantage of it.

However, many financial advisers will more strategically construct portfolios with their clients. They’ll create a financial portfolio that balances your needs against your risk tolerance, and ideally they’ll make the portfolio more stable, at least for the amount of risk you’re willing to take.

A robo-adviser typically uses asset allocation to craft a portfolio that matches a client’s risk tolerance and time horizon, after asking them a series of questions on these topics.

If you’re looking to use asset allocation yourself and don’t have a lot of experience doing it, one alternative is a target-date mutual fund. A target-date fund does the allocation for you, and they’re typically offered in employer-sponsored retirement plans such as a 401(k). With these funds, you select the date when you need the money – say, 2045 – and then the fund gradually adjusts the assets over time so that you’ll have greater safety as they become relied upon for near-term income.

Bottom line

Asset allocation is one of those investing principles that seems so straightforward but can be harder to implement because of the various characteristics of the asset classes. And advisers of all kinds are basing their asset allocations on the historical performance and volatility of the assets, so there are no guarantees about how an asset class will perform in the future.

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