Allocating your investments among different asset classes is a key strategy to help minimize risk and potentially increase gains. Consider it the opposite of "putting all your eggs in one basket." The first step to understanding optimal asset allocation is defining its meaning and purpose and then taking a closer look at how allocation can benefit you and what the right asset mix would be to achieve and maintain it.
What Is Asset Allocation?
Asset allocation is the strategy of dividing your investment portfolio across various asset classes, such as stocks, bonds, and money market securities. Essentially, asset allocation is an organized and effective method of diversification.
The main goal of allocating your assets is to minimize risk given a certain expected level of return. Of course, to maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes.
Equities have the highest potential return, but also the highest risk. On the other hand, Treasury bills have the lowest risk, since they are backed by the government, but they also provide the lowest potential return. This is the risk-return tradeoff. Keep in mind that high risk choices are better suited for investors who have a high risk tolerance (can stomach wide fluctuations in value) and who have a longer time horizon to recover from losses.
It's because of the risk-return tradeoff—which says that potential return rises with an increase in risk—that diversification through asset allocation is important. Since different assets have different risks and market fluctuations, proper asset allocation can help insulate your entire portfolio from the ups and downs of one single class of securities. So, while part of your portfolio may contain more volatile securities—which you've chosen for their potential of higher returns—the other part of your portfolio devoted to other assets remains stable. Because of the protection it can offer, asset allocation can be the key to maximizing returns while minimizing risk.
Deciding What's Right for You
As each asset class has varying levels of return and risk, investors should consider their risk tolerance, investment objectives, time horizon, and available capital as the basis for their asset composition. Investors with a long time horizon and larger sums to invest may feel more comfortable with high-risk, high-return options. Contrastingly, investors with smaller sums and shorter time spans may feel more comfortable with low-risk, low-return allocations.
*Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved