Asset allocation

Life is full of risks and rewards. When investing, the reward for taking on risk is the potential to make more money. Of course, you could also lose more money. The key is finding a balance between your risk tolerance and reward potential. Asset allocation can help.

A powerful decision

The most significant decision to make when building an investment portfolio is determining the asset allocation.¹ How you divide investments among different asset classes can be more important than the actual investment choices made. Finding the right balance between higher and lower risk investments is the key to managing risk in a portfolio. That’s the power of asset allocation.

A portfolio with “class”

Asset allocation involves choosing a portfolio by selecting combinations of investments to meet your specific needs and goals. This is done by dividing the portfolio among different asset classes. The three main asset classes that make up a typical portfolio include:

• Stocks (equity)

  Stocks represent equity or ownership in a corporation. When you own stock in a company, you own a piece of that company. Stocks have historically produced the highest returns; however, they also carry the most risk, with a tendency towards greater price swings — highs and lows — that makes them more volatile than either bonds or money market instruments.

• Bonds (income)

  Bonds are basically loans in which the borrower agrees to pay back principal, plus interest (income), by a certain time. The borrower’s ability to repay typically impacts the bond’s rate. Bonds are closely tied to changes in interest rates — i.e., when rates fall, bond prices rise — and are considered less risky than stocks in general.

• Money Market (cash)

  Money market instruments are investments in short-term debt securities (such as CDs) and government securities (such as Treasury Bills). Like bonds, money market instruments are also tied to changes in interest rates; however, where bond prices tend to move in the opposite direction from interest rates, money market instruments tend to track interest rates. Historically, market conditions that cause one asset category to do well often cause another category to have average or poor returns. That’s why a portfolio that invests in more than one asset category helps reduce the overall risk of losing money.

A balancing act — time and tolerance

The process of asset allocation is a personal one and varies by individual. If you don’t include enough risk in your portfolio, your investments may not earn enough money to meet your long-term financial goals. If too much risk is included, however, your money may not be there when you need it. The key is finding the right balance between risk and reward that works within your time horizon and risk tolerance.

• Time horizon – The expected time to achieve a particular financial goal. Those with longer time horizons, such as retirement, may feel more comfortable taking on riskier investments as they can wait out the inevitable ups and downs of the market; while individuals with shorter time horizons, such as saving for college, would likely take on less risk.

• Risk tolerance – An individual’s ability and willingness to lose some or all of their original investment in exchange for greater potential returns. Those with high-risk tolerance is more likely to risk losing money to get better results; while someone with low-risk tolerance tends to favor investments that will preserve the original investment.

Professional modeling

If you want to put asset allocation strategies to work for you, you may wish to consider seeking help from a professional. Financial planners and asset allocation strategists use computer modeling techniques to analyze the risk and return characteristics of asset classes and then construct model portfolios. Questionnaires based on your total financial situation, risk tolerance and goals can also help professionals build a portfolio with the right asset allocation for you. Of course, using asset allocation as part of individual’s investment strategy neither assures nor guarantees better performance and cannot protect against loss in declining markets.

Asset Allocation vs. Diversification

Asset allocation is often confused with diversification, which can be summed up as “not putting all your eggs in one basket.” While both help to manage risk, asset allocation takes the concept a step further. Asset allocation involves dividing a portfolio among and within different asset classes (such as stocks, bonds and money market instruments). Diversification only involves the investor spreading his or her dollars among a variety of investments, but doesn’t necessarily have to involve different asset classes.