What Is Asset Allocation?

man in demin jacket seating on a couch with a laptop typing

Asset allocation is an investment strategy that involves dividing your portfolio among diverse assets, such as stocks, bonds, cash, real estate and more. This approach to investment can help you balance the risk and reward of each asset class and create a more diversified portfolio.

Here's what you need to know about how asset allocation works, why it's important and how to do it for your own portfolio.

How Asset Allocation Works

Asset allocation is an important investment strategy for both short- and long-term investors. It's as simple as investing your money in different asset classes. Asset allocation works by taking the characteristics of different assets and using them to balance the risk and reward that are inherent in each one.

The right asset allocation for you depends on how much risk you're willing to take on in your portfolio and your time horizon, or how long until you'll need the money.

For example, stocks tend to carry a higher risk-reward ratio than bonds—but because stocks tend to be much more volatile in the short term, investing your entire portfolio in stocks may not be a great idea if you're planning to retire in a few years.

On the flip side, bonds can offer less volatility than stocks, as well as some income in the form of interest payments. But if you're saving for a retirement that's decades away, you can afford to be more aggressive with your investments.

In addition to your time horizon, you'll want to consider your risk tolerance. Even if you're investing long term, if you don't feel comfortable with an aggressive approach to investing that has a high risk-reward ratio, you might opt for a more moderate approach.

There are many different types of assets that you can invest in, including:

  • Stocks
  • Bonds
  • Real estate
  • Cryptocurrency
  • Commodities
  • Futures
  • Cash
  • Artwork
  • Stamps
  • Coins

If you're not sure about the right asset allocation for you, or you don't know what your risk tolerance is, consider consulting with a financial advisor to come up with a strategy you're comfortable with.

Why Is Asset Allocation Important?

Asset allocation is one of the most important strategies an investor can use to minimize their exposure to risks inherent in individual asset classes.

Certain economic conditions can impact all types of investments, but each asset class is affected differently. For example, bonds and other debt securities are more influenced by interest rates than company earnings. And real estate prices in a given market are influenced heavily by supply and demand, location and mortgage interest rates, among other factors. These elements don't generally impact the price of precious metals, stocks or bonds.

If you only invest in stocks and the stock market tanks, your entire portfolio is exposed to those losses. But if only a portion of your portfolio is in the stock market and the reasons for the correction don't impact other asset classes as heavily, your losses may not be as heavy.

Keeping some of your money in cash or an equivalent, such as a savings account, money market account, certificate of deposit or cash management account, means it's not working for you in the same way as the money you've invested in stocks and other asset classes. It also means you're essentially losing purchasing power in the long run due to inflation. But keeping some of your money in cash keeps it safe from volatility.

The important thing to remember in allocating your assets is that you're finding the right balance between risk and reward for your portfolio based on your risk tolerance and time horizon.

How to Allocate Assets

There's no one-size-fits-all approach to asset allocation because strategies will depend on your financial situation, comfort with risk and thoughts about investing. However, there are some approaches you can use to help you find the right balance for you.

Base Your Asset Allocation on Your Age

For investors focused on retirement, one guideline is to determine the percentage of your portfolio that you invest in stocks by taking 100 or 120—depending on your risk tolerance—and subtracting your age. For example, if you're 35 years old, you'd keep between 65% and 85% of your portfolio in stocks and the rest in bonds and other safe investments.

With this approach, you naturally decrease your exposure to riskier assets as you get older, shifting from accumulating as much wealth as possible to preserving the gains you've earned.

Use Target Date Funds

If you don't want to manage this process on your own, you may consider investing in target date mutual funds. These are managed funds that invest in a wide range of assets and securities for better diversification. What's more, they have an expiration date, and as that date gets closer, the managers slowly shift the asset allocation of the fund toward a lower risk-return environment.

You'll choose a fund based on your time horizon. For example, if you're looking to retire in 2050, you'll pick a target fund with that expiration.

Rebalance Your Portfolio

One concept you'll want to keep in mind in all of this is rebalancing. Over time, your percentages can get out of alignment with your preferred asset allocation simply because of the differences in returns among assets.

For example, let's say you have $100,000 and want to invest $85,000 in stocks and $15,000 in bonds, giving you 85% in stocks and 15% in bonds. Because stocks tend to offer higher returns, we'll say your portfolio balance after five years is $150,000 in stocks and $20,000 in bonds. Now, your asset allocation is 88% stocks and 12% bonds.

Rebalancing involves making trades to get your asset allocation back to your original goal. So, in this scenario, you may sell off $5,500 worth of stocks and invest it in bonds to get back to your 85/15 ratio. Alternatively, since you've aged five years, you may now prefer an 80/20 ratio, which would involve selling off $14,000 in stocks and investing that amount in bonds.

Many investment professionals recommend rebalancing at least once a year or when your allocation reaches a certain threshold—for example, you're 5% or 10% off your original allocation. If you don't want to do this on your own, consider investing in a target date mutual fund or with an investment manager or broker who will do it for you.

Consult With a Financial Professional to Develop Your Asset Allocation Strategy

Finding the right asset allocation can be difficult, especially if you want to invest in more than just stocks and bonds or if you want to invest in highly volatile or speculative investments like cryptocurrency.

As a result, it may be a good idea to consult with a financial advisor to help you land on the right approach to your asset allocation. You may even opt to have an advisor manage your portfolio on your behalf, or invest with a robo-advisor, which can be less expensive because investments are made automatically based on your goals and preferences.

The important thing is that you take the time to understand how investing in different asset classes can impact you and that you research and get expert advice on how to apply that to your own portfolio.