Asset allocation: Key to your investment climate
Points to know
- If you start building your portfolio by finding the right mix of asset types, you'll have more control over how risky your portfolio is.
- There are no "good" or "bad" allocations—you'll need to find the one that's right for you based on your own situation.
How investing is like the weather
Imagine you're relocating and you prefer sunny, dry weather. How will you make sure you pick a new home in a place you're going to enjoy? Just checking today's weather won't tell you much. To know whether a certain location meets your needs, you'd have to understand more about its overall climate.
Start with your climate, not your 5-day forecast
Asset allocation—the way you divide your portfolio among asset classes—is the first thing you should consider when getting ready to purchase investments, because it has the biggest effect on the way your portfolio will act.
Just like it's not a great idea to base your relocation on a current run of nice weather in a random city, choosing investments on a whim is unlikely to be a winning strategy over the long term.
Different asset classes tend to act in specific ways, kind of like the investing climate they inhabit. By choosing how to divide your portfolio, you have a certain amount of control over the experience you'll have as an investor.
There's no "best" asset allocation, just like there's no "perfect" climate for everyone—it all depends on what makes you comfortable and gives you a good shot at meeting your goals.
A major type of asset—stocks, bonds, and short-term or "cash" investments.
The sum total of your investments managed toward a specific goal.
How important is asset allocation?
Extensive research has shown that, if you have a diversified portfolio, a whopping 88% of your experience (the volatility you encounter and the returns you earn) can be traced back to your asset allocation.*
In other words, your experience will be very consistent with that of any other diversified investor with the same asset allocation, no matter which specific investments they choose.
In the same way, if you move to San Diego, your overall weather will be very similar to that of someone living in Los Angeles. It won't matter very much which of those cities you choose or what month you move there—what's important is that you're living in Southern California and not New England.
The strategy of investing in multiple asset classes and among many securities in an attempt to lower overall investment risk.
The degree to which the value of an investment (or an entire market) fluctuates. The greater the volatility, the greater the difference between the investment's (or market's) high and low prices and the faster those fluctuations occur.
The profit you get from investing money. Over time, this profit is based mainly on the amount of risk associated with the investment. So, for example, less-risky investments like certificates of deposit (CDs) or savings accounts generally earn a low rate of return, and higher-risk investments like stocks generally earn a higher rate of return.
Once I know my asset allocation, what's next?
Within the broad categories of stocks and bonds, there are many subtypes that have specific characteristics. Depending on your goal, you may choose to invest in some of these specific subtypes.
Use stocks to add the opportunity for growth
Use bonds for income & additional stability
Whichever investments you choose, it's important to make sure you lower your risk through diversification.
A loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.
An investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.
Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.
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*Source: Vanguard, The Global Case for Strategic Asset Allocation (Wallick et al., 2012).
Diversification does not ensure a profit or protect against a loss. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.