Asset Allocation is the way you divide your money between the major categories of investments, called asset classes. The traditional asset classes are stocks, bonds, and cash. Non-traditional asset classes (also known as Alternative Investments) include anything that you can invest your savings in that isn’t a stock, bond, or cash. Gold is an example of an alternative asset class, as is oil or real estate or rare coins or fine art. As a general rule of thumb, the more asset classes you are invested in, the lower your overall portfolio risk will be.
It’s important to keep in mind when you make your asset allocation decisions, that you have to include all of your investable money in the calculation. Some people make the mistake of excluding money that they don’t want to take any risk with. They may have opened a separate “rainy day fund” or an account that they have earmarked for the down payment on their first home, or whatever. The problem with excluding something from this calculation is that it can cause you to be unbalanced. If you have a big chunk of money in an emergency fund, for example, you should count that as part of the cash portion of your overall asset allocation scheme.
The first step in setting up your asset allocation is to add up all the money you have scattered around at various financial institutions. Your biggest account is probably your retirement, either your company 401k plan, your IRA, or whatever you use to sock away your savings for your golden years. Next is probably your brokerage account, where most people put the savings that won’t fit into their retirement accounts (due to IRS rules and limitations). After that comes regular savings accounts, either at your bank or your credit union. Finally there is your emergency fund, the money you have tucked away for emergencies or for big expenses that are coming due within the next year or so. The point here is that you have to include all of your investable money in the asset allocation process.
Let’s assume that when you add up all of your money, you have a total of $100,000. This is your Nest Egg, and it’s the number we’ll use for asset allocation purposes. If you want to keep things a simple and easy as possible, you can allocate this nest egg among the three traditional asset classes of stocks, bonds, and cash. Your allocation would look something like this, using our currently recommended model.
Basic Asset Allocation
Stocks $80,000 80%
Bonds $15,000 15%
Cash $5,000 5%
Total $100,000 100%
How did we arrive at this particular allocation? By making a few basic assumptions about you, and by doing what has worked the best in the past. Our assumptions about you are that 1) you have at least 15 years to go before you retire, and 2) you are not afraid to take an average amount of risk with your investments. Studies have shown that, over long time periods, stocks are the best place to invest your money. So why don’t we put 100% of your nest egg in stocks? Because that would be too risky for the average investor. We put some of the money in bonds and cash because they will not go down as much when the stock market misbehaves. By spreading your nest egg over three asset classes that behave differently from each other, we are reducing the wild, up-and-down swings that we would get if we were only invested in stocks.
Since there’s no such thing as a free lunch, we have to sacrifice something in order to get less volatility in the portfolio. What we sacrifice is horsepower. If the stock market has a great year, and goes up by 30%, we wouldn’t participate fully in that gain. A portfolio that’s diversified with bonds and cash will go up, but not quite as much as a portfolio that’s 100% invested in stocks. But what we’re getting in exchange for this sacrifice is something very valuable. When the stock market has a very bad year, and goes down 30%, our diversified portfolio will not go down as much. And here’s the important thing to keep in mind. The money we’ll save when the market goes down will almost always be more than the money we’ll sacrifice when the market goes up. This isn’t just a theory cooked up by some ivory-tower type who says that this is the way things should work. No, it’s the way things do work in the real world, and there are many studies that prove this point. So just remember, if you want to be able to sleep well at night, spend a little time figuring out the right asset allocation for your particular circumstances. Putting all of your money in stocks may be exciting, but having some of your money in other asset classes is a better bet.What Is Asset Allocation?