It is well known that asset allocation is the single most important decision most investors make. Many stock investors spend most of their time considering the stocks that will go into their portfolio.
However the other two asset classes that make up the asset allocation formula are equally important to investing in the stock market success.
The two other major asset classes are fixed income and cash with stocks being the third leg of asset allocation tool.
If you bumble the decisions on cash and fixed income, you might just negate any gains that careful consideration of stocks has netted you.
As a reminder, the purpose of asset allocation is to reduce the overall risk of your investment portfolio.
Stocks and bonds frequently move in opposite directions under the same market conditions and it is this relationship that helps smooth out the peaks and valleys that might be there in your portfolio if it were only invested in stalks.
When most investors think of fixed income, bonds come to mind as the investment of choice. Bonds come in a variety of flavors from very conservative to very risky, so your decision on bond investments is as important as your decision on stock investments.
Some people lump bank certificate of deposits into this asset allocation class (they usually pay a fixed rate), while others are more comfortable with CDs in the cash class.
Fixed income assets (bonds) are so named because most of them provide a study dividend payment usually twice a year that gives you current income to help offset any gains and losses your socks may incur and add to any gains in your stocks.
There are a wide variety of bonds that offer many different levels of risk and ranges of dividend yields. Younger investors may be okay with investing in mid-rated corporate bonds to earn a higher yield while acknowledging that a certain amount of risk is involved.
Older investors at or near retirement will want to be very conservative with their bond investments since this is a way to preserve capital in challenging markets.
The very conservative will stick to U.S. Treasury issues willingly accepting that conservative low-risk bond investments are going to pay much less than more risky bonds.
Some conservative investors include highly rated corporate issues that pretty much guarantee the face value of the bond will be returned to you at maturity and you will receive a nice dividend in the interim.
Cash is included as an asset class because it is the most liquid investment you can make. In almost all circumstances you have immediate access to your money.
While it may be both easy to sell stocks and bonds under normal circumstances, it is those abnormal circumstances where cash is the handiest. If the market is really depressed and you don't want to sell your bonds prematurely cash is the only cushion that gives you options.
Many people use money market mutual funds or brokerage accounts to park money waiting to invest. Cash is not just money waiting to be invested. You will want to keep a certain percentage of you investment assets in cash.
This cash is not to be confused with your emergency fund of six months living expenses.
The downside is as with any market product that offers liquidity and safety is a low yield in most markets. Cash often pays the least of any investment product.
Depending on your tolerance for risk you may only want to keep a small percentage of your investment assets in cash. Most investors shoot for 10 to 15% of their investment capital in cash, while more conservative investors may want up that percentage.
You haven't completed your investment portfolio until you have decided the asset allocation the makes sense for you and done your best to fill it with the best products available.