Asset allocation means diversifying your investments between different types of assets. This can help protect you from large losses in your portfolio.

An asset can be anything from your home to the right to receive royalties from a book you have written. However, when people talk about asset allocation, they usually mean money invested directly in the capital markets. Below we look at the key role asset allocation plays in your investment strategy.


What is asset allocation?

Asset allocation means that you allocate your money among different assets such as stocks, fixed income securities and cash equivalents. Each of these assets reacts differently to different market trends, so combining these assets in your portfolio will help you minimize losses when the market is down.

In general, the younger you are, the more shares you should own. This is because you have a longer investment period during which you can make up for losses if they occur, and the stock market as a whole tends to rise over time. More experienced investors may have a higher percentage of fixed income stocks and rely more on recurring income than big stock gains.

Asset allocation is a key component of any investment strategy. Your portfolio needs to be diversified, and how you distribute your holdings will partly determine how diversified you are.

Asset Class Types

Each asset class offers different degrees of risk and reward. Here are the three most common asset classes, ranked from least risky to most risky:

Cash: This is the least risky type of asset, but the return is negative when inflation is taken into account. This category includes money market funds and certificates of deposit.
Bonds: There are many types of bonds, but they are all fixed income investments. The safest are US Treasury bonds. They are 100% guaranteed by the federal government and offer slightly higher returns than cash. Government and municipal bonds offer slightly more risk and reward. Corporate bonds offer higher yields but have a higher default risk. This is especially true for junk bonds. You should also look at international bonds, including emerging market bonds, as well as domestic bonds.
Stocks: They are more risky than bonds since you can lose 100% of your investment. Stocks provide the highest returns over time and usually outperform inflation. Shares are divided into three subcategories depending on the size of capitalization: small, medium and large. Like bonds, you should own international and emerging market stocks, as well as domestic stocks.
There are many other classes that you should also consider:

Real Estate: This includes investment property, such as rentals, investments in a real estate investment trust (REIT), or some type of pooled real estate fund. Experts disagree on whether the house you live in, if you own it, should be included in this distribution.
Derivatives: They offer the highest risk and highest return. Keep in mind that you may lose more than your investment.
Commodities: Risk can vary as there are many types. However, most investors should own shares in an oil-related mutual fund, as oil should rise in the long run as supplies shrink. It is generally recommended to invest no more than 10% in gold.
Currencies: Since the dollar is declining in the long run, it is useful to have assets denominated in foreign currencies such as the euro. When the dollar is weak, then the euro is strong. These two mixed economies are the same size, so they compete with each other in the foreign exchange market.
How does asset allocation work?
Consider Sarah, an investor who has $10,000. She decides to split her money into three parts: stocks, fixed income securities, and cash. She first decides to invest 60% of her money in stocks. She then decides to divide this amount between the categories of large companies such as Coca-Cola and Reebok, and small companies that most people have never heard of, called "small caps".

Sarah buys $4,000 in index funds that track large caps and $2,000 in index funds that track small caps. She invests $3,500, or 35%, in a fixed income investment split equally between US Treasury bills and municipal bonds (city or state). Finally, she keeps $500 in cash, which she holds in a money market account.

When the inevitable downturn hits the market, Sarah will be better protected from big losses thanks to her investments in bonds, which are not as volatile as stocks. But when the stock market takes off, most of her stock portfolio will perform well.


Asset Allocation and Your Goals

How much should you allocate for each asset? It depends on three factors:

Your investment goals: Are you planning for retirement, are you already retired, or are you saving money for a down payment on a house?
Time Horizon: How soon will you need the money?
Risk Tolerance: Can you tolerate when your investment drops sharply at times, knowing that you will earn higher returns in the long run?
Your goals, time horizon, and risk tolerance will determine the model you should use. If you can tolerate high risk in order to earn high returns, you will invest more in stocks and mutual funds. People with low risk tolerance will prefer bonds. Those who are risk averse or who need money within the next year should have more cash.
Asset Allocation Versus Diversification

While asset allocation is an important part of building a diversified portfolio, it is not exactly the same concept as diversification. You can spread your money among several types of assets without diversifying them properly. For example, if all the stocks in your portfolio are just a few large-cap stocks, you don't diversify them for better growth.

Diversifying your portfolio means covering different levels of risk and return with different investments. Allocation is one way to do this, but you should always go further and diversify each asset class.

Why proper distribution is important

Allocation of assets based on an individual investment strategy is what almost every investor considers good practice. Even billionaires and institutional investors lose money at certain stakes, but because they are properly hedged, this ensures that they do not suffer significant damage from one bad investment.

The balance between equities, fixed income and cash is also important as this strategy allows for macroeconomic changes beyond the investor's horizon. The correct distribution of funds allows you to take into account currency fluctuations and major geopolitical events, providing the investor with protection from large-scale falls.

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Main conclusions

Asset allocation is the process of allocating your investments among different types of assets to protect against market changes.
Investors typically put some of their investments in stocks, bonds and cash equivalents, but there are other types of assets to consider as well, including real estate, commodities and derivatives.
The best combination for you depends on your investment goals, time horizons and risk tolerance.
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