What Is Asset Allocation, And How Do You Use It Correctly?

When sketching out a retirement portfolio, many complex phrases are thrown around by HR departments, employers and financial advisors — often with little explanation — leaving employees feeling lost and unable to make smart investing choices.

One such phrase, asset allocation, deserves immediate clarification.

In short, asset allocation is a strategic investing style that categorizes your assets and determines their “weight” in your portfolio based upon your unique risk/reward personality.

Asset Allocation: Stocks + Bonds + Cash

There are three categories of assets that comprise a solid retirement portfolio: stocks, bonds, and cash. Each category performs differently, and therefore must be treated differently.

Furthermore, every individual’s portfolio will be different because of his or her unique situation. Depending on the amount of time you have left until retirement (time horizon) and your comfort with risk-reward (risk tolerance), you need to adjust the weight given to your stocks, bonds, and cash.

Retirement Portfolio = (Stocks)x + (Bonds)y + (Cash)z

Before you even begin to decide which stocks and bonds you should invest in, the way you allocate your assets should be outlined. You do not, and probably should not, invest equally in each category.

Unfortunately, there is no magic formula for determining what weight you should place on each of these. While there are some very helpful asset allocation calculators, such as the ones from CNN Money and Bankrate.com, you must consider the implications of what categories you emphasize in your retirement portfolio.

To help you get a feel for what your asset allocation might look like, first take a closer look at your time horizon and risk tolerance.

Time Horizon

The amount of time you have left until your desired retirement date can affect how you invest. If your time horizon is broader, you may feel more comfortable making riskier investing choices because you have time to recover financial if those risks do not produce adequate results. If your time horizon is on the narrow side, you may not feel at ease with higher risk investing choices, regardless of the potential rewards.

One of the key elements in a retirement blueprint is the longevity of your investments. Short-term investing strategies look quite different from long-term investing strategies. As you inch closer to retirement, you might need to adjust your investments as your long-term goals transform into short-term goals.

Risk Tolerance

The second important factor to consider in weighing your assets is your personal risk tolerance. This is your comfort with risk and reward. Think of the old adage “a bird in hand is worth two in the bush” to determine your risk tolerance personality. If you are satisfied with the “single bird” that you physically have now, you are likely a low-risk tolerant individual. If, on the other hand, you would rather wait and see if you can capture the “pair of birds” through time and patience and luck, you are likely a higher-risk tolerant individual.

While there is always risk involved in investing, different assets inherently carry different risk and reward potentials. For example, stocks traditionally have the greatest risk and highest returns. Bonds carry moderate risk and moderate returns. Cash and cash equivalents are low risk, but have minimal return.

Asset Allocation Is Not Diversification

Diversifying your portfolio is more complex than asset allocation. As you can see, asset allocation is essentially determining what percentage of your investing will be attached to which asset categories. Diversification involves looking further into those categories and dividing them into sub-categories. A quick warning: while it might seem that diversification within your asset allocation is just as important, it is secondary to how you allocate your resources in the first place.

A final piece of advice: Be flexible. Since there is no perfect equation or formula for determining every individual’s asset allocation, you can shift your own equation as your time horizon shifts. As with most things financial, keep an eye on your retirement portfolio. Check in on it every year. Reassess your options and the weight you have given to your stocks, bonds and cash equivalents. Be aware that your time horizon is not a steady variable. As time passes, your horizon will narrow. Take this into account and keep on track.

Plus:

10 Simple Changes That Can Save You $20,000 A Year

When To Talk With Your Kids About Finances

When Is It Okay To Dip Into Your Retirement Funds?

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