The idiom, “never put all your eggs in one basket,” can be traced back to the 17th century Spanish novel, “Don Quixote.”
That is exactly what asset allocation is about. It is an investment strategy based on the principle of diversification. Investors balance risk and reward by dividing elements in their portfolio among different asset classes based on their goals, time horizon, and risk tolerance. According to Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? by Roger G. Ibbotson and Paul D. Kaplan, asset allocation drives up to 90% of the returns (and volatility) of a diversified portfolio.
For example, an investor in their 20s might be willing to tolerate more risk, so a larger portion of their portfolio is in the stock market because they have longer to weather the inevitable market dips. As they get closer to retirement, they may shift to more stable assets like certain bonds and the asset allocation mix shifts over time. They may invest in a money market account or a short-term certificate of deposit — examples of cash and cash equivalents — if they are saving for a major purchase like a car or house.
Three Main Asset Classes
There are three main asset classes in investing — cash and cash equivalents, fixed income, and public and private equities.
- Cash and cash equivalents — This includes interest savings accounts, money market accounts, certificates of deposits, and the money in your pocket.
- Fixed income — These include bonds. It’s essentially a loan to a company or public entity, like a city, or even the federal government. They promise to pay you back, with interest (known as a coupon), after a certain period, or maturity.
- Equities — This is an investor’s ownership in a company. In publicly traded companies it’s represented by stocks that are bought and sold daily on a public exchange like the NYSE. Private companies can be accessed by investing in various types of private equity funds.
Different Asset Allocation Types
Some people use different strategies based on where they are in life.
There are age-based strategies involving subtracting their age from 100 and then investing the difference as a percentage in equities. Based on that equation, a 35-year-old would put 65% of their assets in equities, and 35% in fixed income.
Others invest in life-cycle funds that adjust their allocation the closer it gets to a specific calendar date. The expectation is the investments will become more conservative the closer the investor gets to their likely time of retirement.
We prefer creating a diversified portfolio to weather various markets by looking at your specific situation, your needs, timing, income streams and spending habits.
Disclaimer: The content in this material is provided for informational purposes only and should not be relied upon as recommendations or financial planning advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.