You’ve heard of it and have a general idea that it’s something you should be doing. But what is asset allocation, exactly?
Asset allocation is the process of dividing the funds in your investment portfolio among stocks, bonds, and cash and equivalents based on your goals, timeframe, and risk tolerance.
So, what is best for your financial situation and goals? Read on for a quick breakdown of:
- Why it’s important and what to consider for your needs
- How asset allocation works
- The difference between the three asset classes
Why is Asset Allocation Important?
Choosing the right asset allocation attempts to maximize your returns relative to your risk tolerance. In other words, it can reduce your risk and increase your potential returns.
Asset allocation is a strategy focused on your needs instead of near-term market performance. That said, it removes emotions from critical financial decisions, making it easier to invest wisely based on your current situation and goals.
How Does It Work?
Simply put, you divide your investments among stocks, bonds, and cash based on your investment horizon (i.e., how long until you’ll need your invested money) and risk tolerance. You invest more in stocks when your timeframe is longer, and your risk tolerance is higher. As your timeframe or risk tolerance declines, you reduce your stock exposure and increase your fixed income and cash to provide more downside risk protection.
Your asset allocation strategy should be dynamic, meaning you should evaluate it at least yearly. This includes assessing your portfolio’s performance, income, expenses, goals, timeline, and risk tolerance. Work with your financial advisor to determine what adjustments you should make.
Understanding the 3 Main Asset Classes
Next, you might be wondering about the difference between stocks, bonds, and cash and equivalents. What should you invest in and when?
- Stocks: Stocks tend to offer the highest growth potential but are generally riskier and more volatile. That’s why they are typically recommended for long-term investments, such as retirement savings.
- Bonds: These fixed-income investments tend to have less volatility and more downside risk protection but also provide lower historical returns. Bonds fall somewhere between stocks and cash regarding the ideal timeframe.
- Cash and cash-like assets: Cash equivalents like savings accounts, money markets, and CDs can offer some potential upside with very low risk. Cash is best for short investment horizons, like saving for a vacation or home renovation in a year.
For example, an investor with a high-risk tolerance (e.g., someone in their early 20s with decades until retirement) may have an aggressive portfolio mix of 80% stocks, 15% bonds, and 5% cash. On the other hand, a more conservative investor (e.g., someone in their mid-50s nearing retirement) may have a mix of 60% stocks, 35% bonds, and 5% cash.
Protecting Your Money with Asset Allocation
Asset allocation is a crucial step in building your portfolio. Consider it the “how” of your portfolio mix. It should come before security selection, which is the “what”—the specific types of stocks, bonds, and cash equivalents you choose.
Since everyone’s finances and goals are different, there isn’t one asset allocation formula that works for every portfolio. You’ll need to work with your advisor to determine the best strategy for minimizing your risk and maximizing your returns.
Do you need guidance as you build your portfolio? Carlson’s advisors will be happy to discuss your current situation and short- and long-term goals to establish the ideal asset allocation for your needs. Let’s chat and get to know each other today!
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