If you’ve read a little about personal finance, you’ve probably heard the term “asset allocation.” I talked about it a bit in my post about how my accounts are allocated between retirement and non-retirement assets, but it is an important topic and one that deserves more attention. Today, I’m going to explain asset allocation in more detail and share my own asset allocation.
What is asset allocation?
One of the most important parts of building an investment portfolio is diversification. You wouldn’t want to have all your money invested with one company because if something happens with that company, you risk losing all of your money. By diversifying and investing in many different companies and different types of assets, you minimize your risk of loss. Yes, there is always the possibility that one company will perform poorly, but ideally you will have other stocks in your portfolio that will hold steady or perform well and therefore balance out the poor performers.
This balance of different types of investments is called asset allocation. Investments are typically classified into different categories, such as large cap, small cap, foreign, bonds, etc. A diversified portfolio will have a mix of assets in each of these different categories. Each type of asset has a different level of risk. Cash is the safest but it has very little potential upside. On the other end of the spectrum are stocks, which have high potential return but are also very risky. The specific allocation you choose is personal and should reflect a variety of factors, including your investment time horizon, your risk tolerance, your other investments (i.e. property), etc.
What does an asset allocation look like?
Let’s look at a few examples. In scenario 1, let’s say that you are like me – saving towards a retirement that is decades away. You are young and you can afford to take some risks now because you have time on your side and can weather a market downturn if need be. In this case, you would want to have a fairly aggressive, high-risk asset allocation that is heavy in stocks with only a small amount of money invested in bonds and cash.
In scenario 2, let’s say that you’re my parents – saving towards a retirement that is only a few years away. In this case, your time horizon is much shorter and therefore you can cannot afford to take on as much risk. If the market crashes and you rely on your investments for your living expenses, you might be forced to sell assets at a loss. In this case, you want to have a more conservative asset allocation that has plenty of cash and other low-risk investments such as bonds or CDs to help you weather downturns and preserve value.
My asset allocation
When I first started investing, I did a ton of research to determine what the right asset allocation was for me. As with so many things in personal finance, my allocation was dictated by my own personal values and goals. I am primarily saving for the long term (for things like my retirement and my currently non-existent children’s college educations), and I only invest assets that I don’t plan to use for at least five years. With this in mind, I selected a pretty aggressive but well diversified portfolio, broken down as follows:
When I invest, I try to keep my balances roughly in line with these percentages. There are many ways to do this – from investing on your own to utilizing managed funds that match your target allocation – but that is a topic for another day.
How to build your own asset allocation
There is a lot of wisdom out there about ideal asset allocations based on various factors. I’ll leave this one to the experts and just point you in the direction of some resources that I like.
- I’m a big fan of Schwab. It is currently where I have all of my personal investments. They have low fees and good customer service. They also have some great resources regarding asset allocation, including this article outlining various asset allocations based on risk tolerance.
- Vanguard is another highly reputable investment company renowned for their low fees. They have a great online tool that will help you determine the right asset allocation based on your inputs. I’ve played around with it and found it to be very useful.
- Investopedia is a great resources for all things investment-related, and this article provides a very thorough overview of asset allocations, the risk levels of various investments, and suggested asset allocations.
What is your asset allocation? Has it helped you achieve your goals?