It’s important for investors to decide where and how to invest their money. Are stocks, bonds or perhaps cash the way to go? For many investors, a combination of these three basic asset classes may make sense.
A key component of investing is determining how to allocate your money among various types of investments — also known as asset allocation. Choosing the right asset allocation will balance out potential returns with potential risks.
What is asset allocation?
Asset allocation is based on the adage that you shouldn’t put all your eggs in one basket. In the case of investing, it’s about how you allocate your money between the three basic asset classes mentioned above. A proper asset allocation is one that balances an investor’s time horizon for their investment goals with their tolerance for risk (defined here as the risk of investment losses).
Within the three basic asset classes, there are a number of sub-asset classes to consider as well.
Stocks are divided into sub-asset classes in a number of ways, but a key differentiator is market capitalization. Market cap is defined as the share price of a stock times the number of shares outstanding.
These are the basic types of stocks based on the market capitalization of individual stocks (or the average of stocks held in a mutual fund or ETF).
- Large-cap stocks
- Mid-cap stocks
- Small-cap stocks
Large-cap stocks generally are larger companies, many of which are household names like Apple, Facebook, IBM, Johnson & Johnson and Microsoft.
Large-cap, mid-cap and small-cap stocks also can be divided into categories, such as growth and value. Growth stocks are companies that are growing faster than the average of a benchmark like the S&P 500, while value stocks may be undervalued compared to the average for the benchmark. Stocks classified as a blend are a mix of growth and value.
Stocks of domestic U.S. companies and companies headquartered outside the U.S. also are divided by market cap and investing style.
Within bonds, there are a number of sub-asset classes. Some are based on the type of bond, such as government and corporate.
There are asset classes based on the maturity of bonds, including those with long-term, intermediate-term and short-term maturities. As a general rule, bonds with a longer time until maturity have a greater risk of price fluctuation over time. Bonds generally are less volatile than stocks.
Cash and cash-like investments generally are the least risky components of a portfolio and therefore generally offer the lowest returns.
Money market funds invest in a variety of short-term interest-bearing securities and are not insured by the Federal Deposit Insurance Corporation (FDIC). Money market accounts are government-insured, however.
Certificates of deposit (CDs) are interest-bearing accounts issued by banks. Your money is committed for a period (three months, a year, etc.), and you receive interest payments during that time while regaining access to your money at the end of the CD’s term. CDs are FDIC-insured.
Why asset allocation is so critical in investing
Asset allocation helps investors choose a mix of investments in line with their risk tolerance, time horizon and financial goals. A classic 1986 study by Brinson, Hood and Beebower asserted that over 90% of a portfolio’s return was determined by its asset allocation. While this has been debated over the years by financial professionals, regardless of the actual percentage, asset allocation is an important factor in your investment performance.
Asset allocation and the concept of diversification go hand in hand. Diversification is a process that mixes a number of different investments within a portfolio. The main idea behind diversification is that different types of investments will do well under varying market and economic circumstances.
Correlation between investments describes the relationship between the movement across two investments. This is a statistical measurement. A correlation of 1 between two asset classes or investment vehicles means the movement between the two is perfectly correlated. A correlation of -1 means there is no correlation and the two asset classes move in the opposite direction.
For example, U.S. large-cap stocks and bonds have a correlation of -0.18 with each other. This means that factors influencing the performance of large-cap stocks and bonds have a very low correlation. Additionally, the correlation between these two asset classes is negative.
A well-diversified portfolio uses an asset allocation that contains some holdings that are not highly correlated with each. This can mean that some investments will do very well when the stock market does well, while other holdings might lag the market at times.
Overall, having some holdings that are not correlated can serve to mitigate a portfolio’s downside risk.
How to choose an asset allocation that’s right for you
An investor who’s just starting out might have a portfolio that includes just a few holdings. It doesn’t take a large number of holdings to achieve diversification.
If you’re a younger investor, your initial asset allocation might be more aggressive and heavily tilted toward stocks. You have a long time until retirement, and the short-term ups and downs of the stock market really don’t impact you.
Your asset allocation will evolve over time. Goals such as saving for your children’s education, purchasing a home, starting a business and saving for retirement will be factors in determining the right one for your portfolio. These and other goals will have different time frames and needs that could impact your asset allocation.
Additionally, your asset allocation will need to be maintained. Investments will perform differently over time. You will want to rebalance your portfolio back to your target allocation periodically to ensure it properly reflects your risk tolerance.
For those who are not comfortable doing their own asset allocation, there are some options.
Target-date funds are professionally managed portfolios that are geared toward a target retirement date. For example, a 2040 fund would have an asset allocation that is geared toward someone who is retiring in or near the year 2040.
There are a number of asset allocation calculators available online for you to try out. These calculators typically will use a questionnaire to break down your situation — including your age, when you will need to access the money and other factors. Then, they will take this information and determine an optimal one for you.
Robo-advisors can offer another way for investors to gain access to professional asset allocation advice. These services utilize algorithms (formulas) to do an asset allocation for you based upon your situation. They generally are registered as financial advisors and will manage your investments for you.
A financial advisor routinely devises an asset allocation for their clients as part of the process of investing their money. A good advisor will review your allocation periodically and adjust it as your situation changes.
Asset allocation is a crucial aspect of investing for investors of all ages. A well-constructed one can help you realize your investing goals. It’s all about balancing your potential return against a level of downside risk. The right allocation can help you achieve your investment goals and not take excessive risk while doing so.