What is Asset Allocation?

Asset allocation is a financial strategy for diversifying investment money into various asset classes based upon your goals, the amount of risk you can tolerate, and the length of time until you plan to use the money. Many people identify an asset as real or personal property that they own, like a home. For our purposes here, an asset is an investment.

Investment assets are broadly grouped into three classes: stocks, bonds and cash.

• Stocks represent ownership in a U.S. or foreign corporation. Sometimes foreign stocks get put into their own asset class, defined as International. Stocks can be further broken down into more specialized classes, which are based upon the market value of the company or industry sector.
• Bonds represent debt or loans to a corporation, or various levels of government.
• Cash is your liquid, readily accessible money. This asset class would consist of money market funds, treasury bills and other types of liquid assets.

Each asset class tends to have its own unique characteristics and degree of risk, and performance that may differ from that of other classes in different economic environments. For example, during periods of strong economic growth, many stocks will generally rise in value. If strong growth leads to rising interest rates, bonds will generally decline in value.

Diversification

By using an asset allocation strategy you spread your investments among the various asset classes. This is also known as diversification. Diversification helps lessen the negative impact on your portfolio when there is a market downturn in one specific asset class. For example, if all your investments are in stocks and the stock market has a large decline, the value of your investments may also drop significantly. However, if you have money invested in different asset classes, such as bonds and cash, such risks may be less significant.

One way to further diversify your investments, while also using an asset allocation strategy, is to invest in mutual funds. These products, by design, are broadly diversified within specific asset classes and generally actively managed by experienced investment professionals. Mutual funds are available in a broad array of asset classes, such as stocks and bonds, making them excellent choices for any investor's portfolio, which may make them an appropriate choice for many investors’ portfolios.

Remember the old saying "Don't put all your eggs in one basket"? Well, that saying aptly describes asset allocation. Asset allocation is the process of investing your monies into various asset classes, so if one performs poorly it doesn't impact your whole investment strategy. It allows you to diversify your investment portfolio, which, in turn, helps reduce risk. Putting all your money in one investment, just like putting all your eggs in one basket, is very risky. If that investment goes down, you could lose a large part of your investment. Asset allocation helps reduce this risk. Keep in mind that diversification cannot eliminate the risk of investment loss.