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.
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.
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.
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.