Asset allocation is a key part of being a successful investor. According to both research and academic studies, asset allocation is the most important thing you can do to achieve your financial goals. Allocation affects both your portfolio’s total long-term return and its risk. Other things, like choosing which securities to buy and when to buy them, have a very small effect on your investment returns. Unfortunately, the least understood decision is also the most important one for making money.
How do you divide up your assets? People usually get asset allocation and diversification mixed up. They think it might have something to do with investing in multiple groups of similar assets. Ask investors to make a list of the things they might invest in. “Growth stocks,” “bonds,” “large caps,” and sometimes “international stocks” are the most common answers. But they can only choose from options within a single asset. For instance, someone who wants to buy stocks in the technology industry might invest in five or six companies, all of which are in the same industry. This lowers the risk if one of the companies fails, but it doesn’t help if the tech industry (or the whole stock market) goes downhill.
Asset allocation goes beyond diversification to lower risk across all types of financial assets (cash, stocks, bonds, commodities, real estate, and even venture capital or hedge funds). Investments and risk can be further broken down into subcategories of stocks, such as large-cap, mid-cap, small-cap, value vs. growth, and international vs. domestic. Bonds can also be broken down into subcategories like short-term and long-term, tax-free, high yield, convertible, emerging markets, floating rate, and international vs. domestic. Investors can divide their portfolios into a number of asset classes and categories by using a number of different combinations.
It might seem risky to add high-risk asset classes and investments to a portfolio. But putting together assets that do different things, or even things that do the opposite of each other, increases the return and lowers the risk of the whole portfolio. For example, stocks from other countries are seen as “riskier” than stocks from the same country. Still, the prices of U.S. stocks often rise on the same day that the prices of international stocks fall, and vice versa. This is known as a negative correlation. Losses from one asset are made up for by profits from another. By lowering the daily price swings of our entire portfolio, combining international and U.S. stocks actually reduces investment risk.
The past shows that many markets have prices that don’t go together. When interest rates go down, bonds do much better than stocks in a slowing economy. When the economy is too hot, inflation helps the commodities market make a lot of money. But the timing of such events is hard to predict, and the fact that returns can vary means that any investor is taking a risk. If you choose to buy only stocks, only bonds, or any other single asset class, you are more likely to lose money if that market doesn’t do well.
Asset allocation is powerful because it lowers risk while increasing returns. Combining different types of assets is not a simple way to lower risk, though. Each asset has its own risk level, but many of them move in price in the same way (their prices go up and down together in any market). When you combine investments that go well together, the risk of wild price swings goes up. Risk and expected return must also be weighed against each other. When it comes to price changes, high-yield assets tend to be very volatile. To protect against big drops in value, these assets must be matched by investments with lower rates of return.
For asset allocation to work, you need to find the right mix of assets that balances reward with a level of risk that you are comfortable with. Asset research and investment analysis are needed for proper allocation planning. There are tools that can help the independent investor, which is good news. Popular financial websites help independent investors by providing links to educational resources and software that helps them build their portfolios based on a survey of financial questions. For more experienced investors, there are many books that carefully explain the theory and practice of asset allocation, which is also known as MPT (Modern Portfolio Theory). Casual investors can buy mutual funds that are made to automatically allocate assets based on when they plan to retire. Realistic investors can look into the many financial planners and advisory services that offer asset allocation portfolios that fit their needs.
Think carefully about your choices. Each solution comes with its own set of pros and cons. Choose a style that is similar to your own. How important is it to divide up your assets? It’s the single most important factor in how well you do financially in the long run.
