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What Is Asset Allocation & Why Does It Matter?

Financial experts like to use jargon — it’s a character flaw, I must admit. And one piece of jargon you hear often is “asset allocation.” While this can sound intimidating, it’s actually a very simple concept.

Asset allocation is how you divide (allocate) your savings (assets) between different types of investments. Those types of investments typically include stocks, bonds, cash, and sometimes real estate or alternative investments.

When we talk about asset allocation, we typically talk in percentages.

As in: let’s allocate X percent in stocks, Y percent in bonds, and Z percent in cash. 

So, we know what asset allocation is — but why does it matter?

To answer that question, I want to take a detour to talk a bit about the three most common types of investments: stocks, bonds, and cash. What are they? What are they good at? What are they bad at? Where do they fit in?

Stocks

When you own a share of stock, you own a little tiny slice of a company. You are often called a “shareholder.”

Stocks, as an investment, are very good at one thing: growing in value at a rate faster than inflation over long periods of time. It’s not very sexy when you phrase it like that, but put another way, an investment in a broad cross section of stocks through index funds or mutual funds is likely to double in value roughly every eight years.

That means the $10,000 you invested in 2012 could be worth $20,000 by 2020.

But that opportunity to grow comes at the cost of unpredictability. I can’t tell you with certainty which way the stock market is headed on any given day, month, or even year (and neither can anyone else).

Stocks are unpredictable, and their value can swing widely in a very short time.

Because they are unpredictable in the short term but able to offer robust growth in the long term, stocks are the investment that drives long-term growth in your portfolio.

For investors who are building wealth as well as investors who are living in retirement, this growth is vital to outpacing inflation and building wealth over time.

Read: What Is Diversification? And How Do I Do It?

Bonds

When you own a bond, you own an entity’s debt obligation. This means that the bond issuer — the entity that borrowed the money — is obligated to pay you interest during the life of the bond and pay you the loan principal when the loan matures. You are often called a “bondholder.”

Bonds, as an investment, are very good at being predictable in the near term.

The value of a bond typically does not move around as much as the value of a stock. They are also very good at providing regular income.

But this reliability and predictability come at a cost too, which in this case is growth. The value of bonds grows much more slowly than that of stocks.

Because they are more predictable in the short term and offer income, bonds are a bit of an investing multi-tool. They can bring stability to your portfolio of investments while you are accumulating wealth, and they can also serve as an income source in retirement.

Cash

When you own cash, you own a highly liquid asset that can be readily used to buy goods and services.

Cash is good at being completely predictable. The balance in your bank account floats up and down only with deposits and withdrawals. Cash is not subject to daily fluctuations in value.

But cash provides no income and no growth. That makes cash vulnerable to inflation.

Cash has little role in your long-term investments. There may be times when you want to hold more cash, but in general, I seek to limit cash holdings in investing accounts.

But no matter what life stage you find yourself in, cash is an important part of your overall asset mix. You need an adequate emergency fund and cash to cover your day-to-day expenses.

Read: How much should I be saving? And where should I put it?


Why It Matters

Your success (or failure) at meeting your financial goals is driven in large part by your asset allocation. (The other big driver is behavior.)

Your asset allocation should be dictated by your ability to tolerate risk and your investing time horizon.

If you take too little risk, you may not reach your goals.

If you take too much risk, you may bail out during rough markets, which will make it harder to reach your goals.

Having an asset allocation that fits with your goals, ability to tolerate risk, and investing time horizon will give you a leg up. You’ll save yourself the heartache that comes with losses you can’t handle and give yourself a realistic expectation of what type of investment return you can expect.

To a large extent, your expected investment return will dictate the amount you should be saving.

While the concept is simple to understand, it may be hard to use in real life.

If you find yourself struggling to figure out how to invest your savings, that’s a signal that consulting with a Financial Advisor may be a good next step.

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Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.