What Is Asset Allocation?
How This One Strategy Can Help Boost Your Investments
Asset allocation refers to diversifying your investments among a combination of equities, fixed-income and cash equivalents. An "asset" can be anything from your home to your right to collect royalties on a book that you wrote. When people describe asset allocation, they are usually talking about cash invested directly into the capital markets.
So What is Asset Allocation?
Asset allocation means that you spread your money between a combination of equities, fixed-income and cash equivalents. General practice is that the younger you are, the higher percentage of equities you own. This is because you have a longer investment period in which to make up losses if they occur. The stock market has always trended up over time, so if you are young time is an asset as well. More seasoned investors might have a higher percentage of fixed income holdings and are more reliant on regular income than on big stock gains.
Asset allocation is a key component of any investment strategy. Your portfolio should be diversified, and how your assets are allocated partially determines how diversified you are. Your asset allocation will likely change as you age to accommodate changes in appetite for risk.
Example of Asset Allocation
Sarah, an investor, has $10,000. She decides to split her money into a three-way combination of equities, fixed-income, and cash. First, she decides to put 60 percent of her money into equities. She further decides to split this between large companies like Coca-Cola and Reebok, and small companies that most people have never heard of, called small-caps.
She buys $4,000 in index funds that track large-cap companies and $2,000 in index funds that track small-cap companies. That's a total of $6,000, or 60 percent of her money, in equities. She puts $3,500, or 35 percent, in fixed-income investments. She splits this evenly between U.S. Treasury bills and municipal (city) bonds. Finally, she keeps $500 in cash, which she holds in a money market account.
Why Proper Allocation Is Important
Many investors would say that Sarah is well diversified in her holdings. She isn't investing strictly in stocks, bonds, or cash. Rather, she has a mix of the three in her portfolio, which will serve her well when the market becomes volatile.
This does not mean that she will necessarily profit during market downturns, but it can mean that she is protected against total loss through a process called "hedging," which postulates that when one sector goes down, the opposing one tends to rise. Many of the worlds largest funds place hedge bets against their larger holdings, just in case their research was wrong. Through hedging, an investor can limit downside potential.
Allocating assets based on your individual investment strategy is what almost every investor would consider good practice. Even billionaire institutional investors like Bill Ackman and Warren Buffett lose money on certain bets but, since they are properly hedged, it ensures they will not go down on a single bad investment.
A balance between equities, fixed income, and cash instruments is also important because it is a strategy that allows for macroeconomic movements beyond an investors horizon. Allocating properly allows for fluctuations in currencies and larger geopolitical moves, giving the investor a safety net against large-scale changes.