We all know that investing in the stock market is about risk and reward - more specifically, achieving the maximum reward for the minimum risk.
Since we can't know in advance what portions of the stock market will do well and which will languish or when the whole market will soar or plummet, it is important to setup your portfolio to cover as many situations as possible.
Asset allocation spreads your portfolio over several asset classes and is linked to the time horizon of your goals and your individual tolerance for risk.
Some studies indicate that your overall investment success is more closely tied to achieving the correct asset allocation than which assets you actually buy. The historical justification for this is that different classes of assets don't necessarily move in the same direction at the same time.
Stocks have historically outperformed bonds, but they have also experienced periods of extreme volatility when an appropriate investment in bonds would have cushioned the turmoil.
If you knew when stocks were going to soar or fall, you wouldn't need to worry about asset allocation. You would have perfected the art of market timing - getting in and out of the market at the right times. Unfortunately, as I have previously noted, no one can do that with any consistency.
What Is Asset Allocation?
Asset allocation allows that we will have less than ideal returns in exchange for some real-world protection against market ups and downs. It should be noted here that asset allocation is no guarantee against losses. The best it (or any system) can do is reduce the odds of a major loss and improve the odds for a gain.
Although asset allocation is widely accepted as a prudent measure, it is not universally accepted. In particular, some financial professionals view it with disdain, mainly because they want nothing to do with bonds for any reason.
Asset allocation attempts to build a portfolio that is appropriate for your < a href="http://stocks.about.com/od/riskreward/a/Understandrisk.htm">risk tolerance, time horizon, and ultimate goal. As you have probably concluded, asset allocation is more important for your long-term goals than for the short-term ones.
You may already be practicing asset allocation if you participate in a 401(k) plan at work. These plans will typically give you up to 20 choices (mostly mutual funds) of how to invest your money. If the plan is well designed, the choices will cover a range of investments that let you place your money in appropriate instruments on any percentage basis you choose.
Asset Classes Explained
Asset classes are the securities and other investment tools you use to reach your financial goals. Your strategy with asset allocation is to use a diverse group of securities to create your portfolio. Here are some examples of the most important asset classes:
- Stocks
- Fixed income or bonds
- Money market or cash equivalents
These are the high level categories of asset classes. You need to drill deeper into each category to see the whole picture. Although many financial professionals suggest combining all of these classes, that's a bit much for first time investors.
For most people, stocks, bonds and cash will be all they need or want. You can build a fine portfolio with these three asset classes.
For beginning and not-so beginning investors in the stock market, note that finding and creating the right asset allocation model will take some time as you sort out what you need. Some financial professionals suggest you can achieve proper asset allocation with individual stocks and bonds.
This is probably not a goal you want to start with from day one. It takes much more time and research than you might think. So, I suggest you take a beginning step with mutual funds for both stocks and bonds.
As I dig deeper into the asset classes of stocks and bonds, I will suggest some beginning steps you might take with mutual funds.
In upcoming articles, I will drill down into each of these asset classes.
