Just as a mutual fund diversifies your investment by spreading it out among a variety of stocks and/or bonds, dividing your investment into various asset classes further diversifies your investment and potentially reduces your risk. As such, asset allocation is the process of determining how much of your total investment portfolio should be allocated to different asset classes.
What is an Asset “class”?
Investment assets are categorized into asset classes based on their characteristics. Cash equivalents are an asset class that carry very low risk, are typically very liquid, but provide a lower return. Bonds (a.k.a. – “fixed income”) typically provide slightly higher returns, are somewhat less liquid and may carry more risk, while stocks (a.k.a. – “equities”) have the potential to produce high returns, but also carry higher risks.
How do I determine an appropriate Asset Allocation?
Three factors are often used to determine an appropriate asset allocation: The investment timeframe, the investor’s goals and the investor’s risk tolerance. Often the investment timeframe will largely dictate the asset allocation. If the time frame is short, less than approximately two or three years, a large percent of the portfolio will be allocated to cash equivalent type investments such as CD’s and money markets. As the timeframe increases, a larger percentage can be allocated to stocks or bonds.
An investor whose goal is to grow their money over a longer period of time may allocate a higher percentage to stocks, while one whose goal is to create monthly income may choose a higher percentage of bonds. Regardless of timeframe, investors who choose to allocate a portion of their portfolios to either stocks or bonds must be comfortable watching the value of their accounts fluctuate both up and down.
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The information presented here is for educational purposes only and should not be considered financial, tax or investment advice. Please consult a qualified professional.
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