You’ve probably heard the words “asset allocation,” but what does that term mean? Let’s start with a technical definition and then a common phrase.
Investopedia defines asset allocation as “the implementation of a strategy that attempts to balance risk and reward in a portfolio by apportioning investments to various assets according to a person’s goals, time horizon, and risk tolerance.”
That definition is a mouthful!
Now for the common phrase
Don’t put all your eggs in one basket.
When constructing a diversified portfolio for you, financial advisors usually use three main asset classes:
- Stocks (also called equities)
- Bonds (also referred to as fixed-income securities)
- Cash or cash equivalents (e.g., money market funds or certificates of deposit)
The percentage of money in the portfolio that goes to stocks versus bonds versus cash or cash equivalents is your asset allocation.
Here’s an example
Stocks are considered to be riskier and more volatile assets than bonds. However, stocks have historically returned an average of 7-10 percent, while bonds have returned an average of 3-5 percent. You are taking on more risk by investing in stocks, but you may expect to make a better return on your money over the long-term. When investing in bonds, an investor would expect a lower return but would also expect less volatility.
Your goals and time horizon are important components of deciding what assets to invest in. If you are saving for a large purchase in the next 1 to 3 years – buying a car, or saving for a down payment on a condo or house – you will want your money in cash or cash equivalents so that you are sure your money is there when you need it. If you are a young person investing for a longer-term goal – saving for retirement, for example – then you have plenty of time to put more of your money to work in the stock market.
Something else to consider
Finally, knowing your risk tolerance is imperative when investing because it helps determine how to allocate the assets in your account. For example, let’s say we have two clients saving for retirement, Joan and Terri. They both have 25 years before they will need to draw on money in their retirement accounts. Joan is comfortable taking on risk and Terri is not.
If the stock market drops 30% or more, as happened in 2008, Joan would be able to keep her money invested and not panic. Terri would be more inclined to sell her investments and put all her money in cash. That means she would be selling her assets at the bottom of the market, locking in the losses.
For Joan, she may be comfortable with an 90% stock and 10% bond allocation. Terri may need to be in a far less aggressive portfolio. If the market experiences a sudden drop, both Joan and Terri will experience volatility in their portfolio, and Joan’s will likely be more volatile than Terri’s because of her higher percentage in stocks. However, both investors are likely to be able to ride out the storm and stay invested in their portfolios because their portfolios match their individual comfort with risk.
Andrea L. Blackwelder, CFP®, ChFC and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with Wisdom Wealth Strategies.