Asset allocation is the practice of investing across asset classes in a portfolio in order to balance the different potential risks and rewards. The three main asset classes are typically stocks, bonds, and cash.
Asset allocation is closely tied with portfolio diversification. Diversification means spreading one’s money across a range of assets. In a general sense, it’s like taking the age-old advice of not putting all your eggs in one basket. An investor can’t avoid risk entirely, but diversifying their investments can help mitigate the risk that one asset class poses.
In addition to stocks, bonds and cash, some investors also allocate money into real estate, commodities, private-equity or hedge funds, as well as even cryptocurrencies. Determining what kind of asset allocation makes the most sense for you depends on personal goals, time horizon, and risk tolerance.
Here’s a deeper dive on how asset allocation works.
The most common assets you can invest in are:
• Stocks: Stocks can be volatile, with the market going up and down, but they can also offer a higher return than bonds over the long run.
• Bonds: Bonds, such as Treasurys or municipal bonds, can be lower risk because they’re backed by government entities, but they also offer lower returns. There are higher-yield corporate bonds, which have greater returns and risk, but also tend to be less volatile than stocks.
• Cash or cash equivalents: This includes money in savings accounts or money market accounts, as well as certificates of deposit or Treasury bills. Obviously, the returns on these are very low but they’re also very secure. The biggest concern with cash investments is if inflation outpaces the return, then you technically could be losing money (e.g. future purchasing power).
The 100 Rule
A common rule of thumb is known as The 100 Rule: Subtract your age from 100 and that’s the percentage of your portfolio that should be invested in stocks. For example, if you’re 25, then the 100 rule would suggest that 75% of your portfolio be in stocks and 25% in safer investments, like bonds, Treasurys, cash or money market accounts.
Target date funds are funds that more or less follow this style of rule — automatically adjusting the make-up of stocks vs. bonds as you near your target retirement date.
However, there are some caveats to this rule of thumb — people are living longer, every person’s situation may be different, and this is really only an asset allocation suggestion for retirement, not other financial goals you might have. Some financial advisors have even adjusted it to “The 110 or 120 Rule” because of increases in life expectancy.
Other Diversification Strategies
For investors who want to be more active in their investment decisions or have more complicated financial goals, there are other asset allocation strategies. Other investments can include real estate, commodities (raw materials like gold or coffee), private equity or hedge funds, and direct investments in private companies.
There are even more exotic assets, like different types of cryptocurrencies or even things like fine art. All of these can have a place in your investment portfolio depending on your goals, timeframe, risk tolerance, knowledge and willingness to stay informed.
Another way is to use a long-term strategic asset allocation, like the ones discussed above, but then adjust it for short-term opportunities, like say you want to invest in the short-term in a particular stock or company, or put money into a venture capital fund.
It can be difficult to diversify your portfolio on your own — you would have to buy each individual asset, which can be confusing and can come with fees and minimums. You can invest in funds that index the market or funds with target dates (which change the asset allocation automatically over time in order to target a specific retirement date).
That’s why investors might choose to use mutual funds or exchange-traded funds (ETFs) to easily construct a well-diversified asset allocation. A mutual fund or ETF is essentially a pool of money from many investors, which then invests in a number of assets, allowing investors to own a small portion of all of those assets. It can give instant diversification with one investment.
Related: How Do Mutual Funds Work?
What’s a Good Asset Allocation Strategy?
The best asset allocation to meet your financial goals depends on a number of factors, most importantly your timeframe and your risk tolerance. For example, if you’re very far away from retirement, then you may be able to handle more risk in your retirement portfolio. But if you’re investing for your teenage kids’ college education, then that’s a shorter time frame and you probably shouldn’t take as many risks.
Your risk tolerance will also affect how you react to ups and downs in the market. Multiple studies have correlated the frequency with which you check your portfolio to losses over time — the more you stress over it, the more likely you are to pull your money out when you should just wait and stick with it.
So if you’re going to be someone who worries about every little blip in your investment portfolio, then you might need less risky investments. No investment is without risk, but you can spread the risk out across different assets and asset classes. But in general, higher-risk investments often have higher returns.
How to Rebalance Asset Allocation
The other factor to consider is when to rebalance your portfolio in order to stay in line with your asset allocation goals. Over time, the different assets in your portfolio have different returns, so the amount you have invested in each changes—one stock might have high enough returns that it grows and makes up a significant portion of your stock investments.
If, for example, you’re aiming for 70% in stocks and 30% in bonds, but your stock investments grow faster until they make up 80% of your portfolio, then it might be time to rebalance. Rebalancing just means adjusting your investments to return to your desired portfolio make-up and asset allocation.
There are many rebalancing strategies, but you can choose to rebalance at set times — monthly, quarterly, or annually — or when an asset changes a certain amount from your desired allocation (for example, if any one asset is more then 5% off your target make-up).
In order to rebalance, you simply sell the investments that are more than their target and buy the ones that have fallen under their target until each is back to the weight you want.
The effect of asset allocation has been studied over the years and while the findings varied, one thing has remained constant—how you allocate your money to different assets is vitally important in determining what kind of returns you see.
However, it’s more than just diversifying within each asset class—it’s also about diversifying your entire investment portfolio across asset classes and styles. In general, for instance, stocks are considered riskier than bonds—though there are also different kinds of bonds.
There are many different kinds of funds with different asset allocation, and a fund doesn’t guarantee diversification—especially if it’s a fund that invests in just one sector or market. That’s why it’s important to understand what you want out of your portfolio and find an asset allocation to meet your goals — which may require professional help.
SoFi Invest® offers Automated Investing for those who need help finding the right mix of assets in their portfolio. Investors who want to pick and choose stocks, ETFs and fractional shares themselves can take advantage of the Active Investing platform.
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