Asset allocation, at its most basic level, is deciding how to spread (allocate) the risk across your investment portfolio: stocks vs. less-risky instruments such as bonds and certificates of deposit (CDs). These decisions will be the primary determinant of your investment performance; i.e., your portfolio’s rate of return.
Beyond this seemingly simple decision, you must consider how much to invest in domestic stocks, international stocks and emerging markets stocks, how much in value stocks and growth stocks, how much in large cap stocks and small cap stocks.
You must also decide whether some industries and sectors should be emphasized and if any should be shunned.
Within the asset class of debt instruments, you must decide how much to allocate to long-term and short-term securities, riskless treasuries, slightly risky investment grade corporates and riskier high-yield debt, taxable bonds and municipal bonds, domestic and foreign bonds. Finally, you must decide how much cash to hold.
THE LESSON
You are unique. Your asset allocation decisions reflect your uniqueness: age, level of risk aversion, tax status, health, whether you have dependents, and other personal factors. In addition, your decisions should change as you age. Stocks are risky.
Therefore younger investors should invest more in stocks; a typical basic asset allocation for a 30-year-old might be as high as 95 percent in stocks. A 70-year-old with a modest amount of wealth might only be 30-50 percent in stocks. If the stock market were to decline by 60 percent, a younger person can work longer and save over many years to recoup market losses; an older person close to retirement has fewer options.
As you spread your money over different types of assets, you will also achieve the benefits of diversification. An investment advisor can guide you through these decisions. Choose the advisor and the allocation wisely.
