Asset allocation is a strategy to balance the risk and the reward by investing in different asset classes that react differently in a same market event. When one part of your portfolio is down, another part may be up, helping to smooth out the overall return of the portfolio.
Main asset classes include equities, bonds, cash and cash equivalents. The goal of stock investment is growth and this asset class has the highest potential for long-term returns and highest risk. Equity value fluctuates widely in the short-term.
The goal of bond investment is income and stability. Bonds provide regular income through interest payments and generally less volatile than stocks. Bonds are safer than stocks but still carry some risk such as when an issuer defaults.
Cash and cash equivalents include savings accounts, money market funds and short-term government debts such as T-bills. This asset class is for safety and liquidity and carries the lowest risk. The main risk for this asset class is inflation which can slowly erode the purchasing power.
How the Allocation is Determined?
Financial goals: What are you saving money for? Short-term goals will need safer assets such as cash and bonds, while for long-term goals, you can take on more risk for higher growth potentials by investing asset classes such as stocks.
Risk tolerance: Risk tolerance refers to psychological and financial ability to handle market swings. If you cannot stand 20% drop in the portfolio causing you to panic and sell your holdings, you are considered to have low risk tolerance and need more conservative asset allocation such as bonds and cash.
Time horizon: This measures how long you can or have to invest. The general rule is the longer your time horizon, the more you can afford to invest in riskier asset classes such as stocks and this asset class gives your investment time to recover from any market downturns.
Why Rebalancing Matters?
Your investments grow at different rates over time. If your stocks have a good year, they suddenly make up 70% of your portfolio instead of your target 60%. This means you are taking on higher risk than what you planned originally. Rebalancing is the process of selling some of the winners (stocks) and buying more of the losers (bonds) to get back to the original target allocation such as 60/40. It makes you “buy low and sell high” keeping your risk level in check. Rebalancing allows you to have a disciplined approach that can improve long-term results.