Everything You Need to Know About Asset Allocation

Photo Credit: Lending Memo

Asset allocation is strongly connected to diversification. The idea of diversification is to lower investors' risk by spreading funds over multiple investments and to avoid devastating losses that could occur from an investment in a single stock. Diversification should be a crucial goal in portfolio construction and is a prudent approach to mitigating the inherent volatility in the capital markets.

Volatility can occur in an instant and pose significant risks for investors' portfolios and their long-term financial goals. Asset allocation is a strategy that considers a multitude of asset classes, the investors' unique financial circumstances as well as risk tolerances.

Every asset class has different risk and return characteristics. The inclusion of different asset classes (stocks, bonds, cash, commodities, real estate) in a diversified investment portfolio is a powerful way to counter the uncertainty in the capital markets and the uncertainty of future asset class returns.

As such, knowledge about the benefits and disadvantages of various asset classes is important in order to protect the investor from downside risk and also offer attractive return potential.

1. Stocks
Stocks offer investors the best long-term return potential and can be categorized depending on market capitalization or industry or a variety of other definitions. Stocks do well as the economy expands and interest rates are in an upward cycle.

Stocks are particularly suitable for young investors with long investment horizons who have ample time to rebound from market corrections. Older investors, on the other hand, should gradually shift their assets toward fixed-income investments that provide recurring income.

2. Fixed Income
Bonds are usually referred to when professionals talk about fixed income investments. What separates bonds from stocks is their different risk/return profile.

As debt, bonds usually are above equity in the capital structure which makes them safer investments than stocks. This lower risk comes at a price though: Lower potential returns.

Bonds are mostly bought for their relatively low risk and steady cash flow income. In addition, bonds offer significant diversification benefits when held in equity-heavy investment portfolios.

3. Cash
Having cash on hand can make all the difference. There is no investor in the world who didn't wish his cash position was larger when stocks were on sale in times of a market panic.

Cash largely translates into the ability to act when opportunities arise and is therefore extremely valuable in times of market distress.

4. Commodities
A small allocation of investment funds to the commodity asset class (for instance, 5%) can make a lot of sense as the risk/return characteristics of commodity investments (such as gold, silver, copper, or aluminum) are vastly different than the ones for stocks or bonds.

Commodities usually do well in the beginning stages of an economic recovery and can offer investors substantial upside potential.

Moreover, commodities such as gold serve as "safe harbor" investments that are doing well when the world is on the brink of another geopolitical crisis.

5. Real estate
Many investors have some exposure to real estate in case they bought a home or apartment.

The real estate asset class behaves yet differently than the other asset classes discussed above. Real estate is a great bet in an expanding economy where house prices rise. Real estate value can originate from two sources: Rental income and underlying property values.

The Foolish Bottom Line
Prudent investors who are serious about building long-term wealth need to utilize all asset classes ranging from stocks to commodities and real estate in order to create a diversified investment portfolio.

The allocation of funds to certain asset classes will largely depend on the financial goals of the investor as well as his age. Younger investors should allocate larger amounts to stocks in their investment portfolio and older investors should accentuate bond investments to secure their lifestyle.

Over the long run, investors have better chances at meeting their financial goals with a structured portfolio approach that utilizes the advantages of all asset classes as opposed to any single investment in either stocks or bonds.

How to get even more income during retirement
Social Security plays a key role in your financial security, but it's not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.

Read/Post Comments (0) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3080406, ~/Articles/ArticleHandler.aspx, 9/4/2015 9:16:31 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Kingkarn Amjaroen

Kingkarn Amjaroen is a financial analyst taking an interest in the basic materials, retail and financial sector.

Today's Market

updated 32 seconds ago Sponsored by:
DOW 16,102.38 -272.38 -1.66%
S&P 500 1,921.22 -29.91 -1.53%
NASD 4,683.92 -49.58 -1.05%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes