What You Need to Know About Asset Allocation

Simple Asset AllocationToday I’m going to discuss this basic investing concept that everyone should be familiar with: asset allocation.

We all learned about it in our economics classes in high school and college, but I know how quickly we forget.

So, I thought I’d give a bit of a refresher as well as share some new trends in investing using asset allocation strategies.

Asset allocation is the process of splitting up your investment portfolio into the different asset classes. Chiefly, this involves putting different amounts of money into the major three classes of assets: stocks, bonds, and cash. Other asset classes include real estate, commodities, precious metals, and equity holdings. You can also split your assets up even further into different types of stocks. Or cut it the other way and split it up between different industries. If you keep drilling down, you can allocate your funds across thousands of different asset types.

Asset allocation is used primarily for those people investing for retirement or college savings. Why? Because they are looking for long term growth with less risk. But there is no “proper” asset allocation. The asset allocation you choose depends on your own goals, your age, and your risk tolerance. It’s entirely up to you.

Asset Allocation vs Diversification

As a point of clarification, I need to add that asset allocation doesn’t equal diversification (i.e. not putting all your eggs in one basket). Diversification is the act of spreading out your investments into different asset classes, industries, and even countries to achieve a balance of risk and reward. A better way of explaining the difference might be to say that you can have an asset allocation strategy that is not diversified.

For instance, if your investment portfolio is made up of $50,000 worth of your companies stocks, and $25,000 worth of gold bars, you have allocated your assets: two-thirds into stocks of one company, and the other third into a particular commodity. But this portfolio isn’t very diversified. If something negative were to happen to your company, then two-thirds of your portfolio would be at risk. Not good.

Asset Allocation Models

Just because asset allocation is left up to individual choice, it doesn’t mean that people don’t try to come up with the perfect asset allocation model. Do a Google search for “asset allocation model” and you’ll find a hundreds of different models. There are also a few asset allocation calculators out there that will help you find your perfect allocation.

Asset Allocation Strategies

A common strategy is to use a combination of mutual funds, a bond fund, and some cash (via MMA). Most of the models I’ve seen use this strategy and typically look like this for someone in their 30s: 80% stocks, 10% bonds, 10% cash. Another strategy is to use one fund, a tactical asset allocation fund, which can give you an asset allocation across the three asset classes from one fund. Finally, there are target date retirement funds. These funds expand on the tactical asset allocation fund idea by changing the mix of asset classes to a more conservative approach as the fund ages. I use a single target date fund in my Rollover IRA. An advantage to using this type of fund is that I don’t have to re-balance my portfolio each year.

Key Takeaways for the Long Term Investor

  • Understand the asset classes. Learn about stocks, bonds, and cash. Understand the risks involved in each.
  • Get to know your risk tolerance. Take one of the many tests online to determine your risk tolerance. Be sure to retake the test every 5 years as your assets grow and situation changes.
  • Look at examples of “proper” asset allocation. Study the different strategies out there. Take note of what you like and dislike.
  • Make sure your portfolio is allocated according to your risk tolerance. Finally, make sure your portfolio matches up with what your goals are. Re-balance your portfolio each year to ensure you stay in line with your goals.
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Last Edited: January 26, 2013 @ 1:29 pm
About Philip Taylor

Philip Taylor, aka "PT", is a husband and father of two. He created PT Money back in 2007 to share his thoughts on money and to meet others passionate about managing their finances. All the content on this blog is original, and created or edited by PT. Read more about Philip Taylor, and be sure to connect with him on Twitter, Facebook, or view the Philip Taylor+ Google profile.

2 comments
Aury (Thunderdrake)
Aury (Thunderdrake)

Ah! This is particularly interesting. The difference between asset allocation and diversification. There's definitely a grey area there, but I think you did a fantastic job of bridging black from white.

I never really considered myself a diversified investor with the exception of stocks. So this helps give a bit of assurance on the definition!

Panda Mike
Panda Mike

I would also add that it is very important to know all the available asset classes.

For example, you can have several asset classes where you can invest your money and still stay in a "fixed income" asset category (such as gov bonds, corporate bonds, preferred shares, junk bonds, etc.).

Some are riskier than others, even in the fixed income.