What is Asset Allocation? Diversification? Rebalancing?
Asset allocation is a term that refers to the strategy you use to put your money into different types of investments.
You are dividing your money across different asset classes like stocks, bonds and money market securities.
Asset allocation tries to achieve the right balance of risk and reward as defined by your:
- Risk tolerance (Do you have the emotional ability to handle losses? Can you afford to lose the money?)
- Goals (How much are you trying to accumulate? In what time frame?)
- Investment time frame (When do you need the money?)
They key to good asset allocation is diversification. You want your investments spread among the right variety of asset classes or investment types and you want diversity within those classes.
Diversification is important since particular investment types and individual investments tend to perform differently over time and expose you to different kinds of risk and return. For example if you have investments in the the stock market and the stock market suffers a correction then perhaps you will see a return in your other holdings like bonds.
An ideal asset allocation strategy for a retirement account might have a mix of stocks, some bonds and – perhaps also a bit of exposure to commodities or real estate.
And, you want to be diversified within each asset class as well. For example:
- Your stock holdings would be diversified in a variety of companies in a range of industries
- You might hold an assortment of bonds — some short term and some longer term.
Finally to get the maximum return while minimizing risk investors should regularly re-balance their portfolios by adjusting their holdings based on returns on a regular basis. For example if you own the technology stocks for a year and they massively outperform your investments in oil stocks then after a period of time you should sell some of the winners in and invest that money across the rest of your portfolio to even things out.
More recently highly automated investment and with automatic re-balancing for low cost has been provided by Robo-Advisors.