What Is Asset Allocation?

Investing, Investing Strategy
what-is-asset-allocation

It’s a rough estimate, but about one out of 10 investing articles contains some variation on the phrase “don’t put all your eggs in one basket.”

Those eggs are your money, and the baskets are the various asset classes you can choose to invest that money in. Deciding how many eggs — or dollars — go into each basket is called asset allocation.

Asset allocation plays a key role in the amount of risk you take with your investments, as well in your investment returns. When you pick an asset allocation, you are spreading your investable dollars across categories of investments, based on your goals, risk tolerance and time horizon.

Key asset classes

Asset allocation is a big-picture view of your investment portfolio: What asset classes do you want in your portfolio, and how much of your money do you want to put in each?

Asset classes are simply groups of similar investments. In a broad sense, the asset classes in question are stocks, bonds and cash (or cash equivalents like money market funds, certificates of deposit or savings accounts. You can buy stocks and bonds individually and in mutual funds, which are baskets of many investments grouped together.

All of these asset classes bring something of value to your portfolio. Stocks offer the greatest potential for long-term growth but also expose you to the greatest risk. Bonds balance out that risk and provide a steady stream of income. Cash bails you out of a jam when your roof fails and it starts raining inside your house, or lets you meet short-term goals like a down payment on a home or car.

Cash isn’t an investment, however, and will most likely make up a very small portion of a long-term portfolio. If you’re young, you may not have cash in your investment portfolio at all. As you enter retirement, you’ll likely hold more cash to meet your short-term spending needs.

Within each class you can dial down further, dividing stocks by geography, industry and market capitalization — in plain English, a company’s size — or dividing bonds by short- or long-term, type of issuer and geography. You can even ladder bonds, buying a variety of maturity dates so you can move into a better rate if interest rates rise.

» Learn the basics: What is a stock?

Choosing the best asset allocation

There’s no precisely right or wrong asset allocation, but you do want to settle on the best investment mix for your needs — and by “needs,” we mean your ability to stomach risk, your investment goals and your time horizon.

First, consider when you need the money. If you’re saving for a wedding in two years, you probably don’t want to put any of your money in stocks or bonds; you’ll instead heavily favor cash or cash alternatives. You don’t want to pull up to your wedding day and find that the market wiped out your catering budget.

If you’re saving for retirement, you can look at your current age and your planned retirement age. If the latter is 30-some years away, for example, most of your portfolio should be invested in stocks. You have time to weather market fluctuations in that case, and your primary focus is growing your money during that stretch.

As you start preparing to leave the workforce, you’ll slowly shift toward a less risky allocation. Contrary to popular belief, though, there’s no need to move your entire portfolio into bonds and cash on your retirement day. Remember, retirement isn’t the end — it’s a time period that might last 20 years or more. You need your money to continue to grow throughout those years, and that means maintaining a stock allocation.

» New to stocks? Read our guide on how to invest in stocks

Once you have a time horizon, consider your risk tolerance. Risk is necessary for reward, but taking on more than you can handle can easily lead to rash reactions. You might be more prone to pulling out of the market every time you see a flash of red on CNBC, for example, which means a company is selling at a low. (You’ve no doubt heard that the goal is the opposite: Buy low, sell high.)

Diversifying within each asset class helps reduce your risk significantly, without reducing your potential for returns. When you diversify, instead of buying one large-cap stock and calling that section of your asset allocation good, you’ll buy a number of large-cap stocks or, better still, a large-cap mutual or index fund.

» Lower your risk: Here’s more on how to diversify your portfolio

Shortcuts to asset allocation

Want to get right to it? There are tools that allow you to buy a specific asset allocation suitable for your goal in one swoop.

One is a target-date fund, a kind of mutual fund that holds stocks and bonds. If you plan to retire in 2050, you might choose a 2050 target-date fund, and it would automatically allocate your assets with that year in mind. Like other mutual funds, you’ll pay an expense ratio — a percentage of your investment to cover the fund’s costs — each year. Hybrid fund expenses currently average 0.74%, according to the Investment Company Institute.

Another option is a robo-advisor, which is a computerized investment manager. These services ask about your goal and risk tolerance and then spit back a portfolio that fits the bill. At a digital robo-advisor, you’ll pay a management fee that typically starts at 0.25% of your assets per year.

» Explore the top online advisors: See NerdWallet’s analysis of the best robo-advisors

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.