Asset allocation and why it matters

You’ve probably heard the old proverb, “Don’t put all your eggs in one basket.” Despite its age, its wisdom is still sound – especially when it comes to investing.

Think of your portfolio as the basket in question. Now, think of the stocks, bonds or other securities in your portfolio as the eggs. Just as it can be treacherous to carry a basket filled with teetering eggs, so it can often be unwise to have a single asset type dominate your portfolio.

Of course, this outlook varies widely between investors. More conservative investors tend to stick to a higher percentage of relatively safe investments, like bonds or index funds, while the adventurous types may prefer a higher percentage of stocks for their typically higher-risk, higher-reward nature. And while at least some diversification within your asset allocation is good – and necessary – to maintain a robust, healthy portfolio, how you do it will largely depend on you, the investor.

So how do you choose the right ratio? It ultimately comes down to your personal risk tolerance, time horizon and financial goals. However, there’s more to asset allocation than that – it’s a fundamental principle that can help you build an investment strategy that works for you.

Let’s dive in.

What’s an asset anyway?

Think of them as short- and long-term financial instruments you can buy or sell as an investor to potentially generate income. Assets can be tangible, like cash or gold, or intangible, like stocks or bonds.

What are the main types of assets?

Assets can historically be broken down into three main classes: fixed income (e.g., bonds), equities (e.g., stocks) and cash and/or cash equivalents (e.g., money market accounts). Other asset classes include – but are not limited to – real estate, cryptocurrency and commodities. To keep things simple, though, we’ll focus on the three classes that are often incorporated into investment accounts.

Different asset classes boast different characteristics. For example, fixed income assets tend to be more conservative in nature, meaning they’re typically lower-risk and lower-reward.

What’s more, asset classes are defined by how they behave over time, too. Fixed income assets, for example, are much less likely to fluctuate in value than equities over a period of time. In periods of market volatility, investors may choose to reallocate their assets to hedge against potential losses.

Equities

Equities like stocks are typically considered a higher-risk asset because of market fluctuations. However, they may offer higher rates of return. Be sure that you consider your risk tolerance before making any investment in equities, and also consider the differences in risk between equities when you do. For instance, investing in an individual stock may have more risk potential than investing in an index fund.

Fixed income

Fixed-income assets tend to be more conservative in nature, meaning they’re typically lower risk and lower reward. For investors who are uncomfortable with a lot of risk and are looking for relatively predictable returns, allocating a good chunk of their assets to this class may align with their risk appetite and financial goals. While no asset is completely free of risk, these assets tend to fluctuate less and are much less likely to fluctuate in value than equities over a period of time. In periods of market volatility, investors may choose to reallocate their assets to hedge against potential losses.

Cash equivalents

Cash equivalents – such as savings accounts, money market accounts, certificates of deposit (CDs) and cash management accounts – are often considered to have minimal risk and are therefore often considered a stable investment asset. That said, they often don’t offer high returns. Especially in an inflationary environment where the cost of living is increasing at a higher rate than any interest being provided, there may be risks to consider with this asset class too.

What is asset allocation?

Asset allocation is an investing strategy in which an investor divides the amount in their investment portfolio among different types of assets – like bonds, stocks and other investment vehicles. Divvying up money among different asset classes and types of investment vehicles within each investment class enables investors to mitigate risks associated with certain assets by investing in more stable assets.

How does asset allocation work?

How you allocate your assets should depend largely on three factors: your time horizon, risk tolerance and personal goals. Time horizon refers to when you need the money from the asset, while risk tolerance is how comfortable you are with the potential of losing money that may come with the possibility of higher returns. When it comes to factoring in personal goals, everyone has different objectives that should be considered while determining an investing strategy.

How does this work in practice? If you want to spend the money quickly (e.g., purchasing a car within the next year), this would be considered a short time horizon. In this case, it may be wiser to allocate your money into more conservative, stable assets – like cash or fixed income. The returns may be minimal, but so are the risks. In a similar vein, if you’re close to retirement, it may be wise to avoid higher-risk investments and maintain a more conservative portfolio.

However, if you’re thinking of using the money to retire several decades from now, that would be considered a long time horizon. In this instance, a higher risk strategy may pay off in the long term because you’ll have time for any short-term losses to be smoothed out by long-term gains. In this case, you can potentially take more risk and may therefore choose to invest in higher-risk, higher-reward assets – like stocks or equity funds.

Why does asset allocation matter?

Just as you shouldn’t keep all your eggs in one basket – literally or figuratively – so you should maintain a fairly diversified portfolio to help you weather the ups and downs of the markets. And even though diversification won’t guarantee that you’ll meet your financial goals, it’s part-and-parcel of building a strong investment strategy.

Asset allocation also matters because:

Diversification needs may vary: There will likely be times throughout your investment journey where you’ll have to reallocate your assets due to personal or economic changes or to rebalance your portfolio.

Goals may change over time: In the same vein, it’s common to adjust your asset allocation as you grow older and your financial goals evolve. For instance, younger investors may decide to choose higher-risk investments since they have a longer time horizon. In contrast, investors nearing or in retirement may choose more conservative assets for their relatively stable and predictable returns.

Market volatility is inevitable, but that doesn’t mean you have to stick with the same mix the entire time. An asset allocation strategy will allow you to evolve your investment strategy as you go, which may be important to an investment strategy’s success.

What is a good asset allocation?

The short answer? It depends.

At the outset, we highlighted time horizon, risk tolerance and your personal financial goals as the three main drivers when it comes to thinking about how to allocate your assets. Someone nearing retirement will likely allocate their assets differently than a college graduate just starting their first postgrad job.

Generally, a 60/40 portfolio in stocks and bonds, respectively, has been a historically popular strategy for some investors. This is largely because a mix of stocks and bonds has historically balanced risks and rewards, as they typically move in opposite directions – the market volatility in 2022 notwithstanding. It’s worth noting, though, that despite the benefits of diversification, including building a 60/40 portfolio, it ultimately doesn’t not protect against investment losses completely. There are also many strategies to consider for how to allocate assets beyond the 60/40 rule.

At the end of the day, you are the only person who can decide these three things for yourself. Let your answers guide your asset allocation strategy, no matter whether you’re doing it yourself or with the help of a financial advisor.

The bottom line

Asset allocation is more than just choosing a few stocks or bonds and calling it a day – it’s a tool investors can use to evolve their strategy, weather market volatility and ideally bring themselves closer to meeting their financial goals. Talk to a financial advisor for more information on which ratio might work best for you and your situation.

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