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What is Asset Allocation?

Asset allocation is one of the most important aspects of personal finance and is also one of the most frequently overlooked aspects as well. The idea behind asset allocation is a relatively simple one: have a portfolio that matches your tolerance for risk while enabling you to meet your future financial goals. The problem with asset allocation is that there is no right answer. There are countless ways to allocate, slice and dice, and thoroughly drive yourself crazy trying to optimize your plan. Ultimately, asset allocation is one of the key determining factors to the success of your portfolio and it is better to have an imperfect allocation plan than no plan at all.

Even the best investment professional must expect that not more than two thirds of his decisions will prove to be above average in profits. Therefore, asset allocation and diversification are the foundation stones of successful long-term investing.

John M Templeton, Chairman of the Templeton Foundations

Overview of Asset Allocation

Asset Allocation can be summed up as "don't put all your eggs in one basket." The premise behind all asset allocation theory is to diversify your investments to protect you against the natural ebb and flow of the financial markets. Determining how much to put in which basket becomes an individual journey in understanding market risks and defining goals for your financial future. Determining your asset allocation can be as simple or complex as you want it. The goal of all asset allocation theories is to match your portfolio with your expectations so that you get the most out of your savings while avoiding any unwanted risks.

In order to understand what allocation is best for you, you must first learn about different assets, plan out an allocation for your needs, and then make sure you rebalance your portfolio every year or so to make sure your allocation still fits your needs. It is also important to slowly move your portfolio into less risky assets as you grow older to protect the growth of the portfolio from potential short-term market declines. Defining the right asset allocation is a highly unique experience and may be different for every person. The important thing to remember is that asset allocation largely determines your portfolio's success over the long term, so it is important to learn about it and create a plan that is right for you.

What are Assets?

Assets are anything you own that can be used as or converted to cash. Most people think of stocks and bonds, but assets also include precious metals, cash, real estate, mutual funds, annuities, and many other things. Most investors will deal with stocks and bonds primarily for their retirement accounts, but it is not uncommon to see real estate or other investments listed in an asset allocation plan.

Stocks and bonds can be broken down into specific groups of assets, which may be based on the company size, company sector, type of bond, or several other attributes. Stocks are commonly broken up by size: small, mid, or large cap, or by investment opportunity: value, growth, or blend. Bonds are typically broken down into corporate bonds, government bonds, or savings bonds with either a short, intermediate, or long term.

Why is Asset Allocation Important?

Besides the act of actually saving money, asset allocation is the most important aspect of financial planning. This is because the allocation of your assets largely determines how your portfolio grows over time. Stocks, mutual funds, and other equities perform better over Certificates of Deposit, savings bonds, or municipal bonds over a long time horizon even though there may be short intervals of time where equities may lose a significant amount of their value. If your portfolio is more bonds than stocks for many years, chances are it will underperform a portfolio weighted towards the stock market. In addition, the effect of compounding interest is lessened when your money grows at a slower rate. Unless you understand what type of risk you are willing to undertake and shape your portfolio around your needs, your portfolio may seriously underperform based on your expectations. Once you have started saving, it is essential you develop an asset allocation plan to maximize your returns based on your tolerance for risk and time horizon.

Next: Learn about risk and managing it in your portfolio
Page last modified 3/21/2012