So, what is it exactly?
Asset allocation is a fancy way of saying “don’t put all your eggs in one basket.”
When you’re building your portfolio, you’ll have a lot of choices about where to put your money. Equities (a.k.a. stocks), bonds, cash, commodities (things like silver or crude oil), foreign and domestic markets, small and large companies—all of those investments behave differently. For instance, equities tend to have a higher risk but also a higher reward. Historically, they’ve earned a relatively high return on investments over time, but they’ve also had moments of steep decline. Bonds, on the other hand, have tended to increase in value more slowly over time but have also suffered fewer big losses. When building a portfolio, investors should consider how much risk they want to take on and then spread their money around according to that risk tolerance. That’s asset allocation.
The precise nature of that allocation is a matter of opinion. The Internet is filled with endless advice, but in reality, there is no right answer: Every investor has a different risk tolerance and a different timetable for investing (the longer you have to invest before you need the money, the riskier advisors believe your asset allocation should be).
What are the pros?
Putting all of your money into the Russian stock market is probably foolish. There’s a chance it will outperform all other investments, but there’s a probably greater risk that it won’t (and a significant risk that it’ll tank). Is that a chance you want to take with, say, your retirement funds? In a nutshell, that’s the advantage of spreading your investments around: You make sure you’re invested in enough sectors to be able to take advantage of positive trends without being wiped out by negative ones.
But in order to really take advantage of the principle, you have to monitor and adjust your allocations. When you’re younger, you want a higher proportion of assets in riskier investments; as you age, you want to move money into more stable places. If you lose your shirt in equities in your 30s, you have plenty of time to make up for losses; if that happens in your 80s, well…you get the idea.
Is there anything to be careful about?
If you’re not willing to pay 1% to 2% of your assets to hire someone to manage your investments, creating a well-diversified portfolio can be difficult to do on your own. Doing the research, buying lots of individual stocks and bonds—that’s tricky stuff. But there are ways to take advantage of professional knowledge without hiring your own wealth advisor. ETFs and mutual funds, for instance, are managed by professionals in order to create a good asset allocation, and the funds have relatively low fees. As an individual investor, you’ll still need to figure out which funds to buy, but that’s monumentally easier than picking individuals stocks and bonds!