Financial Concepts: Asset Allocation

Investors looking to make an investment for a long period of time tend to focus their portfolios on stocks. One reason for this is that common stock tends to outperform most other financial instruments over a long enough timeframe. Investors who are looking to maximize returns over a shorter period, on the other hand, often diversify their portfolios by including investments other than stocks.

It is this principle that helped to guide the development of the concept of asset allocation. Asset allocation refers to an investment technique which aims to balance risk and create diversification within a portfolio by dividing assets across a number of major categories (stocks, bonds, real estate, cash, etc.). Because each asset class in the portfolio experiences different levels of risk and return, each tends to behave differently over a longer span of time. While one type of asset may be increasing in value, another may be decreasing.

One central tenet of the concept of asset allocation is that older investors tend to look for lower levels of risk. After retiring, an investor may need to depend upon savings as the only source of income. Individuals at or nearing retirement age tend to invest more conservatively, as it’s crucial that they preserve their assets at this stage.

How does one go about determining the correct mix of different types of assets in a portfolio? Like many of the other concepts covered in this tutorial, the answer is complicated and depends on who you ask. There are many different approaches to allocating assets. There are a number of general principles (see: Achieving Optimal Asset Allocation), but the most common approach is to shift emphasis toward lower-risk instruments (like bonds and treasuries) as one gets closer to retirement. Of course, a stock market crash or other significant disturbance can still cause problems for those who invest conservatively, as many investors saw in the bear markets of 2000 and 2001. To best determine the course of action for you, it’s recommended that you speak with a professional investment advisor.

In the next chapter, we’ll explore the randomness of the stock market in the “random walk theory.”