Distributing the funds in your investment portfolio among stocks, bonds, and cash is known as asset allocation. The objective is to match your asset allocation to your time horizon and level of risk tolerance. The three primary asset classes are, generally speaking:
Stocks. Stocks have historically provided the best rates of return. Generally speaking, stocks are viewed as riskier or more aggressive assets.
Bonds. Historically, fixed income has offered lower rates of return than equities. As a result, bonds are frequently seen as conservative or safer investments.
Money and items that mimic it Even though you don’t usually think of cash as an investment, there are ways for investors to profit from potential upside with low levels of risk, such as money market mutual funds and cash equivalents like savings accounts, money market accounts, certificates of deposit (CDs), cash management accounts, treasury bills, and CDs.
How Asset Allocation Works
When you use asset allocation, you allocate your assets among stocks, bonds, and cash. Your time horizon—how long until you need the money—and risk tolerance—or how well you can stomach the concept of losing money in the short term for the possibility of higher rewards over the long run—determine the proportional amount of each.
Decision-Making Processes for Asset Allocation
Personal goals, degree of risk tolerance, and investment horizon affect an investor’s portfolio distribution while making investing selections.
- Goal-related variables
Goal factors are people’s goals to save or earn a certain amount of money to fulfill a specific need or desire. Hence, a person’s investments and risks vary depending on their ambitions.
- Risk acceptance
Risk tolerance is the extent to which an individual is willing and able to lose a particular proportion of their initial investment in the expectation of ultimately realizing a more significant return. Risk-averse investors, for instance, hold back their portfolios in favor of safer assets. In contrast, riskier investors stake more of their capital, hoping for greater profits. Find out more about return and risk.
- Time frame
How long an investor plans to invest affects the time horizon element. Most of the time, it is based on the investment’s objective. Therefore, the risk tolerance varies according to the time horizon.
For instance, a long-term investing plan may encourage investors to invest in a more volatile or high-risk portfolio since the unpredictable economic environment might shift in the investor’s favor. Investors with short-term objectives, however, might want to avoid holding riskier
portfolios.
A fund that offers investors a diversified portfolio of investments across different asset classes is called an asset allocation fund. The fund’s asset allocation can be set at a fixed or variable proportion across various asset classes, meaning that depending on the state of the market, it may be permitted to favor some asset classes more than others.
FINAL INSIGHT
Investors can lower risk by diversifying their holdings using asset allocation. Historically, cash, bonds, and stock returns haven’t continuously increased at the same rate. One asset class may outperform during a specific time due to market conditions, while another may underperform. As a result of these fluctuations canceling each other out, investors see reduced volatility on a portfolio basis.
