This is a guest post from ABCs of Investing, a new site for novice investors. ABCs of Investing offers one short and simple investing post each week. Understanding asset allocation is a key piece of financial literacy.

In my last post at Get Rich Slowly, I explained the basics of passive investing and why it’s a good strategy. I explored the differences between index funds and exchange-traded funds (ETFs), and showed how they’re great tools for passive investors. My article ended with a breezy “just pick some basic index funds and away you go”. But in reality there are a few more steps before you actually make any investments.

One of the keys to investing is deciding your asset allocation. “But what is asset allocation?” you ask. Asset allocation is the relative amount of each asset class in your portfolio, and it determines how much risk your portfolio has. Still confused? Let’s take a closer look.

Asset classes
An asset class is simply a group of similar investments whose prices tend to move together. In other words, their price movements are at least partially correlated. 

Asset classes can be defined on a very general level (“stocks”, “bonds”) or on a more specific level (“oil companies”, “municipal bonds”). Since most oil companies make money based on similar variables, such as the price of oil, most oil company stock prices tend to move up together or down together.

The concept of asset classes is important. One of your goals when building an investment portfolio is to practice diversification, to use asset classes that are not correlated to each other. That is, you want a portfolio in which not every investment moves the same direction at the same time.

When your assets are not correlated, if one of your asset classes performs poorly (such as stocks in 2008), then your other asset classes (such as cash) will help make up for it.  This works the other way too — if stocks do well, then your other asset classes will probably lower the overall return. 

Diversification lowers the volatility of your portfolio. If you only own stocks, then you could have years where you have -40% returns — or +40% returns.  If you own a mix of stocks, bonds, and cash, then your best and worst years will be a lot less dramatic than with an all-stock portfolio.

General asset classes include:

  • Stocks. This could be individual company stocks or shares of a stock mutual fund, ETF, or index fund.
  • Fixed income. Any type of bond, bond mutual fund, or certificate of deposit.
  • Cash. Usually money in a high-interest savings account, but could also include money carefully hidden under your mattress.

There are many different asset classes. It’s important to be familiar with the general asset classes (stocks, bonds, cash, real estate, precious metals, etc.) and then learn about more specific classes only if they’re applicable to your situation.

Asset allocation
Asset allocation refers to how much of the various asset classes you have in your portfolio.  An older, more conservative investor might have a retirement asset allocation containing mostly fixed-income investments (80% bonds and 20% stocks, for example). A younger, more aggressive investor might have most of their investments in stocks.

Many people make the mistake of thinking you need to choose between all risky assets (stocks) or all safe investments (cash). In reality, you should pick a happy medium. Riskier assets like stocks have a higher expected rate of return. If your investment time horizon is long enough, don’t avoid stocks completely just because they’re more volatile than fixed income or cash.

A retirement account with a long investment time horizon might have 80% of the portfolio invested in stocks and 20% invested in bonds. If this is too volatile for your stomach and you are have a hard time sleeping at night, consider switching some of the stocks to bonds or cash so that your asset allocation has a less risky profile, such as 60% stocks and 40% bonds.

Investment time horizon
The investment time horizon is the length of time until you need the money in your investment account. Simple, right?

Some asset classes, such as cash, are very safe. If you have $5,000 in a savings account, you can sleep very well knowing that in 6 months you will still have at least $5,000 in that account. If you put your $5,000 into a riskier asset class, such as stocks (or a stock mutual fund), then in 6 months your investment might be worth more than $5,000 — or it might be worth less. (Perhaps a lot less.)

If you’re investing money you don’t need for a long time (20 years, for example), then you might consider investing it in riskier investments such as a stock mutual fund. If you need the money in a shorter time period (like 6 months), then you should invest it in a safe asset class, such as cash. The idea is to maximize the chance that your money will be there when you need it. If you are saving for a house down payment that you need next year, the return you get in that year is not as important as the need for that down payment to retain its value.

There are other factors to consider. For example, somebody approaching retirement might want to start withdrawals from their investments in a few years, but most of the money won’t be needed for many years after they start retirement. Going to a 100% bond portfolio in that situation is probably too conservative.

Rebalancing
Rebalancing your portfolio is an important part of investing. Portfolio rebalancing is accomplished by occasionally resetting the proportions of each asset class back to their original percentage.

For example, assume that Susan has just won $50,000 by playing the lottery. After doing some reading, she decides that her portfolio asset allocation will be 60% stocks and 40% bonds.  

One year later, Susan checks the value of her portfolio and notices that stocks have declined. They now only make up 50% of her portfolio instead of the 60% she considers ideal. The bonds are also now 50% of her portfolio instead of the original 40%. To return to the original proportions, Susan decides to rebalance her portfolio so the asset allocation is the same as when she started.

To do this, she sells some of the bonds and uses the money to buy some stocks. Another option would be for her to make any new contributions only to stocks (and none to bonds) in order to return to the original allocation.

There are a couple of reasons to rebalance. First, by selling asset classes that have risen in value, and by buying other asset classes that have dropped, you are selling high and buying low. Second, if you don’t rebalance, it’s possible for your asset allocation (and investment risk) to become radically different from your intended levels.

Summary
Determining the best asset allocation for your portfolio involves a combination of:

  • Investment time horizon — When do you need the money?
  • Risk profile — Can you handle the ups and downs of the stock market?
  • Rebalancing — This is something you should do once a year or so.

It is difficult for the average investor to watch her portfolio value take wild swings every time the markets jump up and down. With proper asset allocation, it’s possible to lower the amount of risk in your portfolio while still maintaining a decent return, which should help you get better sleep at night!

Previously at Get Rich Slowly, this author shared an introduction to index funds and passive investing. Catch more great articles for beginning investors at ABCs of Investing.

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