Asset Allocation 101
How to invest using intelligent asset allocation to improve results and reduce risk
What is asset allocation?
Asset allocation is how you split your money into the different categories of available investments. Anyone who has any money has an asset allocation.
Here are some examples of asset allocation:
- 100% cash. If you keep all your money in a bank account, this is an asset allocation that is 100% cash.
- 60-40. If you invest $6000 in a stock mutual fund and $4000 in a bond mutual fund, this is a 60% stock and 40% bond asset allocation.
- Couch Potato. This allocation, proposed by newspaper columnist Scott Burns, is 50% stocks and 50% inflation-protected bonds.
- AAII Conservative. This allocation, proposed by the American Association of Individual Investors, is 25% Large-Cap Stocks, 10% Mid-Cap Stocks, 10% Small-Cap Stocks, 5% International Stocks, 40% Intermediate Bonds, 10% Short-Term Bonds
Simply put, an asset allocation allocation is a list of assets and percentages that add up to 100%.
What is an asset allocation portfolio?
Once you purchase assets in various categories to implement a specific asset allocation, you have created a portfolio. For example, the Couch Potato allocation listed above is a "portfolio recipe" that you can turn into a portfolio by buying the following two exchange-traded funds:
- Vanguard Total Stock Market ETF (ticker symbol is VTI)
- iShares TIPS Bond (ticker symbol is TIP)
Why is asset allocation helpful?
The basic principle of asset allocation is to avoid "putting all your eggs in one basket." The idea of asset allocation is that you spread your risk by investing in different types of assets so that you have a more steady return over time.
What are the various types of assets that can be in an asset allocation?
The different categories of investments are called "asset classes." The primary asset classes are stocks (also called equities), bonds, cash, real estate, and commodities.
How do I find an asset allocation that works for me?
There are 5 primary ways you can get an asset allocation:
- Use a model portfolio or "portfolio recipe" from a newsletter or web site
- Buy an All-in-One fund that in turns owns several types of assets
- Hire an investment adviser (either online or local)
- Use a broker
- Build an allocation model from scratch (e.g., based on correlation or macro-economics)
What about all the other ways to invest that I've heard of?
Of course there are other ways to invest your money, such as methods listed below. But AssetAllocationHQ focuses on asset allocation ideas that use the well-known asset classes. We focus on asset classes and investments that you can easily invest in using exchange-traded funds (ETFs) or mutual funds. AssetAllocationHQ does not provide detailed coverage of the following investment ideas:
- Bank accounts and Certificates of Deposit. These are specific examples of the "cash" asset class.
- Managed Futures. This is an investment in the "commodites" asset class.
- Day Trading. This is an investment in the "equity" asset class, where stocks are bought and sold rapidly.
- Stock Picking. This is the process of trying to find the best stocks within the "equity" asset class.
- Variable Annuities. The investments inside of a variable annuity do have an asset allocation, but this investment includes an insurance component and a large commission paid to the salesperson. Also, it can be difficult to get your money out of a variable annuity.
- Collectibles (rare coins, art, antiques). Some consider this to be an asset class, but collectibles can illiquid (i.e., difficult to sell quickly).
- Investing in private companies. This is also called "private equity." This can be risky, but also quite profitable if you choose wisely.
- Venture capital. This is investing in new or young companies. It's similar to private equity investing, but the risks and possible returns are usually higher.
- Rental property. This is a form of real estate investing, but can be complicated.
- Hedge Funds. These funds use a wide range of investment methods and a hedge fund can have its own asset allocation. Hedge funds carry high fees and are only available to "qualified investors" (i.e., those with more than $1 million in investable assets).
- Options trading. This is related to equity investing and involves predicting the future price of a stock.
How do I compare asset allocation ideas?
The best way to compare asset allocations is find a portfolio that has implemented that allocation, and get historical data for that portfolio. Look at the annual percentage return over the past seven years and the risk that has been taken to achieve this return. We discuss these concepts in detail on the Risk vs. Return page.
Sounds good. How do I invest using asset allocation?
- Pick your asset allocation. Consider risk, return, and cost. Don't just look for labels like "aggressive" and "conservative" which may not be accurate indicators of a portfolio's risk.
- Pick the funds to buy.
- Rebalance your portfolio over time.