Asset allocation is a common strategy that you can use to
construct an investment portfolio. Asset allocation isn't about picking
individual securities. Instead, you focus on broad categories of investments,
mixing them together in the right proportion to match your financial goals, the
amount of time you have to invest, and your tolerance for risk.
The basics of asset allocation
The idea behind asset allocation is that because not all
investments are alike, you can balance risk and return in your portfolio by
spreading your investment dollars among different types of assets, such as
stocks, bonds, and cash alternatives. It doesn't guarantee a profit or ensure
against a loss, of course, but it can help you manage the level and type of
risk you face.
Different types of assets carry different levels of risk and
potential for return, and typically don't respond to market forces in the same
way at the same time. For instance, when the return of one asset type is
declining, the return of another may be growing (though there are no
guarantees). If you diversify by owning a variety of assets, a downturn in a
single holding won't necessarily spell disaster for your entire portfolio.
Using asset allocation, you identify the asset classes that
are appropriate for you and decide the percentage of your investment dollars
that should be allocated to each class (e.g., 70 percent to stocks, 20 percent
to bonds, 10 percent to cash alternatives).
The three major classes of assets
Here's a look at the three major classes of assets you'll
generally be considering when you use asset allocation.
Stocks: Although past performance is no guarantee of future
results, stocks have historically provided a higher average annual rate of
return than other investments, including bonds and cash alternatives. However,
stocks are generally more volatile than bonds or cash alternatives. Investing
in stocks may be appropriate if your investment goals are long-term.
Bonds: Historically less volatile than stocks, bonds do not
provide as much opportunity for growth as stocks do. They are sensitive to
interest rate changes; when interest rates rise, bond values tend to fall, and
when interest rates fall, bond values tend to rise. As a result, bonds redeemed prior to maturity may be worth more or less than their original cost. Because bonds typically offer fixed
interest payments at regular intervals, they may be appropriate if you want
regular income from your investments.
Cash alternatives: Cash alternatives (or short-term
offer a lower potential for growth than other types of assets but are the least
volatile. They are subject to inflation risk, the chance that returns won't
outpace rising prices. They provide easier access to funds than longer-term
investments, and may be appropriate for investment goals that are short-term.
Not only can you diversify across asset classes by
purchasing stocks, bonds, and cash alternatives, you can also diversify within
a single asset class. For example, when investing in stocks, you can choose to
invest in large companies that tend to be less risky than small companies. Or,
you could choose to divide your investment dollars according to investment
style, investing for growth or for value. Though the investment possibilities
are limitless, your objective is always the same: to diversify by choosing
complementary investments that balance risk and reward within your portfolio.
Decide how to divide your assets
Your objective in using asset allocation is to construct a
portfolio that can provide you with the return on your investment you want
without exposing you to more risk than you feel comfortable with. How long you
have to invest is important, too, because the longer you have to invest, the
more time you have to ride out market ups and downs.
When you're trying to construct a portfolio, you can use
worksheets or interactive tools that help identify your investment objectives,
your risk tolerance level, and your investment time horizon. These tools may
also suggest model or sample allocations that strike a balance between risk and
return, based on the information you provide.
For instance, if your investment goal is to save for your
retirement over the next 20 years and you can tolerate a relatively high degree
of market volatility, a model allocation might suggest that you put a large
percentage of your investment dollars in stocks, and allocate a smaller
percentage to bonds and cash alternatives. Of course, models are intended to
serve only as general guides; determining the right allocation for your
individual circumstances may require more sophisticated analysis.
Build your portfolio
The next step is to choose specific investments for your portfolio
that match your asset allocation strategy. Investors who are investing through a workplace retirement savings plan typically invest through mutual funds; a diversified portfolio of individual securities is easier to assemble in a separate account.
Mutual funds offer instant diversification within an asset
class, and in many cases, the benefits of professional money management.
Investments in each fund are chosen according to a specific objective, making
it easier to identify a fund or a group of funds that meet your needs. For
instance, some of the common terms you'll see used to describe fund objectives
are capital preservation, income (or current income), income and growth (or
balanced), growth, and aggressive growth. As with any investment in a mutual
fund, you should consider your time frame, risk tolerance, and investing
Note:Before investing in a mutual fund,
carefully consider its investment objectives, risks, fees, and expenses, which
can be found in the prospectus available from the fund. Read the prospectus
carefully before investing.Pay attention to your portfolio
Once you've chosen your initial allocation, revisit your
portfolio at least once a year (or more often if markets are experiencing
greater short-term fluctuations). One reason to do this is to rebalance your
portfolio. Because of market fluctuations, your portfolio may no longer reflect
the initial allocation balance you chose. For instance, if the stock market has
been performing well, eventually you'll end up with a higher percentage of your
investment dollars in stocks than you initially intended. To rebalance, you may
want to shift funds from one asset class to another.
In some cases you may want to rethink your entire allocation
strategy. If you're no longer comfortable with the same level of risk, your
financial goals have changed, or you're getting close to the time when you'll
need the money, you may need to change your asset mix.