Details on Asset Allocation, Its Basics & Various Major Classes

Asset allocation is a term used to refer to how an investor distributes his investments among various classes of investment vehicles (e.g., stocks and bonds). You may have a lot of cash but you do not know how you allocate that cash so that you can make money from that invested cash. That is described as Asset Allocation. Asset allocation is a critical component of investing success. Both research and academic studies show asset allocation to be single most significant factor in determining your financial goals. Allocation influences both the total long-term return and risk of your investment portfolio. Other factors such as security selection and market timing account for a very small percentage of your investment returns.

Asset Allocation Basics:

The main idea behind asset allocation is that since not all investments follow a similar cycle, you are able to balance out the different risk and return cycles in your portfolio by spreading your investment dollars among different asset classes such as stocks, bonds, real estate, commodities, and other assets. It certainly doesn't guarantee a profit or protect you against losses, but it can help you manage the amount of risk you face.

The Major Asset Classes:

Below are the three major asset classes you will generally take advantage of when creating an asset allocation.

• Stocks: Stocks have historically provided investors with a higher average annual return than other types of investments such as bonds or cash alternative. Needless to say, because of their potential for higher returns, stocks are typically more volatile and carry a greater degree of risk than other asset classes such as bonds and cash alternative. Investment in stocks may be suitable for those investors that have a longer investment time horizon.
• Bonds: As mentioned earlier, bonds have historically been less volatile than stocks. Bonds do not provide opportunity for capital appreciation that stocks can potentially provide. However, they may be appropriate for investors looking for a fixed and stable income stream from their investments. In addition, bonds carry interest rate risk with them. When interest rates rise, bond values tend to fall, and when interest rates fall, bond values tend to rise.
• Cash Alternatives: Do not provide much capital appreciation potential or income potential but are the least volatile and risky of the three major asset classes. Nevertheless, they are subject to inflation risk. They are generally highly liquid investments and provide investor with easier access to funds than longer-term investments such as stocks and bonds. Cash alternatives may be suitable for investors with short-term investment goals.

Decide How to Divide Your Assets:

The main objective in using Asset Allocation is to design a portfolio that can potentially give you the return you want while reducing the amount of risk you are exposed to or that you feel comfortable with. Your investment time horizon is critical too, because the longer your time horizon, the more time you have to ride out market ups and downs.