What Is Asset Allocation And Why You Should Pay Attention To It

Asset allocation has been discussed many times in personal finance world. If you go to a financial advisor for the opinions about how to manage your money, I am sure you will hear about it as well.

What is asset allocation? According to Wikipedia, asset allocation is a term used to refer to how an investor distributes his or her investments among various classes of investment vehicles (e.g., stocks and bonds). It basically means how you will allocate your money(asset). For example, if you have $1000, you put $500 in bonds and the other $500 in stocks. Then your asset allocation is 50% bond and 50% stocks.

Why asset allocation is important? Imagine you are preparing a dinner for your family. Will you only get meat but no vegetables? You sure can, but that probably won’t be healthy for your family, at least not in the long term. It stays the same for your investment as well. To put 100% of your money in bonds or in stocks are both not healthy for the long term growth of your money. Having all of your money in bonds might hurt your long term return since historically bonds have lower return than equities(stocks). On the other hand, allocation of 100% stock is simply having too much risks. In a bear market, You might lose the majority amount of money you have if you have put all of your money in stocks. Basically, you do not want to put all your eggs in one basket.

There is no right or wrong asset allocation. How you want to invest your money largely depends on your risk tolerance level. If you are risk averse meaning you do not like risk, capital preservation is very important to you and you are not comfortable seeing your money going down in the short term while trying to achieve long term growth, you would probably like to choose 80% fixed income and 20% stock for your assets allocation. If you are risk neutral and do not mind your money going down for a bit, you might want to consider having 50% in bonds, GICs, and so on and the other 50% in stocks. For people who fall in the category of risk seeking, they would probably choose to invest more than 70% of their money in the stock market and the rest in the fixed income investments. In summary, how you choose your assets allocation will be determined by your risk tolerance level.

There are several ways to diversify your investment. The followings are the examples of assets class:

• cash (i.e., money market accounts, high interest saving account)
• Bonds: investment grade or junk (high yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets
• stocks: value or growth; large-cap versus small-cap; domestic, foreign, emerging markets
• real estate
• foreign currency
• natural resources i.e. oil, natural gas
• precious metals such as gold ,silver and so on
• luxury collectibles such as art, fine wine and automobiles

To further break down equity investments into additional asset classes you might want to consider the following:

• By size:

Large-Cap

Mid-Cap

Small-Cap

• By style:

Growth

Blend

Value

• REITs (Real Estate Investment Trust)
• International Investments: foreign or emerging markets
• Life Settlements

Above are some basics about assets allocation, we might get into the details of some assets classes in the future. If you have any questions, feel free to leave me a comment. If you like this article, please share it by clicking on the “Share This” button below.

Thanks for reading…