Morsa Images / Getty Images In general, the younger you are, the higher the percentage of equities you should own. That is because you have a longer investment period in which to make up losses if they occur, and the stock market has generally trended upward over time. More seasoned investors might have a higher percentage of fixed income holdings and might be more reliant on regular income than on big stock gains. For example, suppose an investor will soon enter retirement and currently has an asset allocation of 80% equities and 20% bonds. As a retiree, the investor wants a more conservative portfolio in case the equity market declines and since the retiree plans to withdraw a portion of the savings each year for living expenses. As a result, the investor opts for a new asset allocation of 70% bonds and 20% equities, along with 10% of the account in cash.
Types of Asset Classes
Each asset class offers different degrees of risk and reward. Here are the three most common asset classes, ranked from the least risky to the riskiest: There are many other classes that you should also consider:
Real estate: This includes investment property such as a rental unit, investments in a real estate investment trust (REIT), or a pooled real estate fund of one type or another. Opinions differ among experts as to whether or not to include the home you live in (if you own it) as part of this allocation. Derivatives: These offer the highest risk and returns. Keep in mind that you can lose more than your investment. Commodities: Risk can vary, because there are so many types. However, most investors should own shares of an oil-related mutual fund, as it should rise over the long term as supplies dwindle. It’s generally recommended that you have no more than 10% allocated to gold. Currencies: As the dollar declines, it’s good to have assets denominated in foreign currencies such as the euro. When the dollar is weak, then the euro might be strong. The two mixed economies are the same size, so they compete with each other in the forex market. Cryptoassets: This is generally a highly volatile asset class that can include cryptocurrencies, crypto tokens, and crypto commodities. These digital assets function differently from each other and need to be assessed with a broader asset-allocation view and with an individual’s risk profile in mind. Some financial planners state that you should only allocate what you wouldn’t lose sleep over if it were to drop to zero.
How Does Asset Allocation Work?
Consider Sarah, an investor who 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% of her money into equities. She further decides to split the amount among the categories of large companies, such as Coca-Cola and Reebok, and small companies that most people have never heard of, called “small caps.” Sarah puts $4,000 in index funds that track large-cap companies and $2,000 in index funds that track small-cap companies. She puts $3,500, or 35%, in fixed-income investments, splitting it evenly between U.S. Treasury bills and municipal (city or state) bonds. Finally, she keeps $500 in cash, which she holds in a money market account. When the market takes an inevitable downturn, Sarah will be better protected against a large loss because of her bond investments, which are not as volatile as stocks. But when the stock market takes off, the large portion of her portfolio that’s invested in stocks will be more likely to perform well.
Asset Allocation and Your Goals
How much should you allocate to each asset? It depends on three factors: Your goals, time horizon, and risk tolerance will determine the model you should use. If you can tolerate high risk to obtain a high return, you’ll likely put more into stocks and mutual funds. Those with a low risk tolerance will favor bonds. Those with zero risk tolerance, or those who will need their money within the next year, should retain more cash.
Asset Allocation vs. Diversification
Although asset allocation is a critical part of creating a diverse portfolio, it’s not quite the same concept as diversification. You can allocate your money across several types of assets without properly diversifying those investments. For example, if the stocks in your portfolio are all securities in just a few large-cap companies, you’re not necessarily diversified for better growth. Diversifying your portfolio means covering a lot of different risk and return levels with your various investments. Allocation is one way to do that, but you should always go a step further to diversify within each asset class.
Why Proper Allocation Is Important
Allocating assets based on an individual investment strategy is what almost every investor would consider good practice. Even billionaires and institutional investors lose money on certain bets, but since they are properly hedged, it ensures that they will not be significantly harmed by a single bad investment. A balance among equities, fixed income, and cash instruments are also important, because it is a strategy that allows for macroeconomic movements beyond an investor’s horizon. Allocating properly allows for fluctuations in currencies and larger geopolitical moves, giving the investor a safety net against large-scale declines.
