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What is 'Asset Allocation'

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

BREAKING DOWN 'Asset Allocation'

There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another individual saving for retirement that may be decades away typically invests the majority of his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the market's short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put their money in a more conservative allocation despite a long time horizon.

Age-based Asset Allocation

In general, stocks are recommended for holding periods of five years or longer. Cash and money market accounts are appropriate for objectives less than a year away. Bonds fall somewhere in between. In the past, financial advisors have recommended subtracting an investor's age from 100 to determine how much should be invested in stocks. For example, a 40-year old would be 60% invested in stocks. Variations of the rule recommend subtracting age from 110 or 120 given that the average life expectancy continues to grow. As individuals approach retirement age, portfolios should generally move to a more conservative asset allocation so as to help protect assets that have already been accumulated.

Achieving Asset Allocation Through Life-cycle Funds

Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

The Vanguard Target Retirement 2030 Fund would be an example of a target-date fund. As of 2016, the fund has a 14-year time horizon until the shareholder expects to reach retirement. As of June 30, 2016, the fund has an allocation of 74% stocks and 26% bonds. Up until 2030, the fund will gradually shift to a more conservative 50/50 mix, reflecting the individual's need for more capital preservation and less risk. In following years, the fund moves to 67% bonds and 33% stocks.

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