Asset Allocation: What It Is and Why It Matters

Asset allocation is the process of dividing investments among different types of assets. The mix of assets in a portfolio can affect its level of risk, potential returns and how it may respond to changing market conditions.

What Is Asset Allocation?

Asset allocation refers to how investment money is distributed among different asset classes. Depending on the investment options available, these may include stocks, bonds, cash or other types of assets.

Why Can Asset Allocation Matter?

Different asset classes can behave differently over time. Some may experience larger price fluctuations, while others may have different levels of income potential, liquidity or risk.

Because of these differences, the combination of assets in a portfolio can influence the overall investment experience. However, diversification and asset allocation cannot eliminate all investment risk or guarantee against losses.

Common Asset Classes

Stocks

Stocks represent ownership interests in companies. Their values can rise or fall and may be affected by company performance, economic conditions and broader market movements.

Bonds

Bonds generally involve lending money to a government, company or other issuer. Bond investments can also involve risks, including interest-rate risk, credit risk and market value fluctuations.

Cash and Cash Equivalents

Cash and similar highly liquid assets may provide easier access to money but can also be affected by inflation, which may reduce purchasing power over time.

Factors That Can Influence Asset Allocation

• Financial goals.
• Investment time horizon.
• Risk tolerance and financial capacity.
• Need for liquidity.
• Income requirements.
• Existing investments and financial obligations.
• Personal and financial circumstances.

Asset Allocation and Risk

The proportion of money allocated to different assets can influence the level and type of risk in a portfolio. A portfolio concentrated in one type of asset may behave differently from a portfolio that contains multiple asset classes.

However, holding multiple assets does not guarantee profits or prevent losses. Individual investments and entire asset classes can decline in value.

A Simple Example

Asset Allocation vs Diversification

Asset allocation focuses on how money is divided among broad categories of assets. Diversification generally refers to spreading investments within and across those categories to reduce concentration in a particular investment or area.

The two concepts are related but are not exactly the same. Both involve managing investment exposure, but neither can guarantee protection from losses.

When Might Asset Allocation Change?

An investment allocation may change over time because asset values rise or fall at different rates. Changes in financial goals, time horizon, income needs or personal circumstances may also affect how a person thinks about an investment portfolio.

Some investors review allocations periodically and may consider portfolio rebalancing when the mix of assets changes significantly from the intended approach.

Important Factors to Understand

• Each asset class can involve different risks.
• Past performance does not guarantee future results.
• Investment values can fluctuate.
• Diversification does not eliminate all risk.
• Costs, taxes and other factors may affect investment outcomes.
• Personal circumstances can change over time.

Key Takeaways

• Asset allocation is the distribution of investments among different asset classes.
• The asset mix can influence portfolio risk and potential outcomes.
• Financial goals, time horizon and risk capacity can be important considerations.
• Asset allocation and diversification are related but different concepts.
• No asset allocation strategy can guarantee profits or prevent all losses.