Tying up your money in the market is always somewhat of a risky move. There’s no guarantee that your investments will thrive and there’s no tried and true way to determine the best place to put your funds for them to grow and earn you money over time. There is however a way to build a portfolio that aligns with your goals, timeline for reaching those goals, and ability to stomach any market shakiness. Enter: asset allocation.
What is asset allocation?
Asset allocation is essentially how much you’re investing in various different asset classes (like stocks, bonds, cash, commodities, real estate, etc.) in order to help mitigate the level of risk you’re assuming. Some asset classes are deemed riskier than others and by not putting all of your eggs in one basket, you’re giving yourself the best possible chance of coming out on top, even when the market takes a turn for the worse.
“Asset allocation matters because it is a key component to the way a portfolio may behave over the investment time horizon. Maintaining a diversified asset allocation is particularly important during volatile times,” says Veronica Willis, Investment Strategy Analyst at the Wells Fargo Investment Institute. “Diversification among asset groups that do not necessarily move up and down together can help reduce downside risk in a portfolio and provide returns that fluctuate less.”
How asset allocation works
When figuring out the right make up for your portfolio, it’s important to remember that your portfolio should be unique and tailored to your own preferences and financial goals. Each investor has their own timeline, unique goals and risk tolerance, and your portfolio should reflect that. A few factors you may want to consider when choosing assets to invest in and determining how much to invest:
- Your risk tolerance: Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision. “Investors with a high risk tolerance can typically withstand a higher allocation to equities, while investors with a low risk tolerance should focus on an allocation blend that has fewer high volatility assets,” says Willis. “Your time horizon may also play into this as well. Investors with a longer time horizon have time to recover from market downturns, and therefore may have a higher risk tolerance than someone with a short investment time horizon.”
- Your investment goals and time horizon: Determining what you’re investing for can help you choose assets that align with your goals. If you’re investing to earn extra income, you’ll want to consider an asset like dividend stocks or bonds. However, if you’re looking for more long-term growth or to add to your nest egg for your future self, you might put more toward equities that will grow over time. “Investors with an objective that focuses on both growth and income may want an allocation that includes a balance between yielding assets and assets that are expected to provide growth,” says Willis.
- Liquidity: An asset’s liquidity tells investors how easily it can be converted into cash without affecting its market price. Some assets are more easily traded for cash like bonds or certificates of deposit. Other assets like a real-estate investment, for example, may be more difficult to easily convert into cash.
What do you do once you’ve built your portfolio?
After you’ve decided on your asset mix, you’ll let go of the reins a bit and rebalance your portfolio periodically. Rebalancing is when you reset your portfolio to get back to a level of risk that you’re comfortable with. Over time, some investments will grow faster than others, which can change your desired holdings and mess up your asset allocation. By rebalancing, you will ensure that you’re not overinvested or underinvested in a particular asset class.
“Rebalancing your portfolio on a regular schedule can help enforce the discipline of buying low and selling high,” says Willis. “Rebalancing at least once a year is a good strategy to make sure that your portfolio is on track and in line with your goals.”
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