If your mother warned you against putting all your eggs in one basket, she grasped the basic concept of asset allocation in financial planning.
A well-balanced mix of asset types can help insulate your portfolio against severe market fluctuations that might disproportionately affect any one type of asset.
Investing is all about taking the assets you have (money, stocks, real estate, etc.) and applying sound financial planning strategies to help those assets grow.
What is asset allocation?
When financial planners talk about “asset allocation,” we’re referring to the mix of investment types you hold across your entire portfolio. Sometimes, we may also use the term to talk about the process used to make decisions about your assets.
Because each individual investor has unique goals and circumstances, asset allocation strategies should be customized to help each investor achieve his or her goals.
Diversification in asset allocation
Smart asset allocation relies on diversification. By including a mix of investment types in your portfolio, we can:
- Reduce the risk of suffering big losses that could occur if you over-invest in a small number of similar securities that fail to perform as expected. If you are overly reliant on one industry or one economic influence, you are taking unnecessary risks.
- Find ways to minimize your taxable gains.
- Ensure the types of assets in your portfolio are specifically balanced to match your appetite for (or aversion to) risk.
Types of assets
Most portfolios can benefit from having a mix of types of assets, including:
- Cash (checking and savings accounts, bank certificates of deposit, money market funds)
- Real estate
Additionally, each type of asset has sub-categories to explore.
Mix it up right
At the end of the day, we see time and again that having a good mix of asset classes yields better investment returns in the long run than individually selecting securities, or trying to game the market by investing in sectors you think are going to go up while decamping from those you believe will decline. Studies have shown that asset allocation is a more sustainable and effective strategy for investment success over the long haul.
Disciplined Rebalancing for Proper Asset Allocation
Markets fluctuate, and it’s not unusual for a portfolio’s asset allocation to drift away over time from an investor’s original target allocation as outlined in their financial plan. When that happens, in order to maintain the desired mix of investment types, it may be necessary to make adjustments by buying or selling certain investments. Financial planners call this process “rebalancing.”
Needing to rebalance doesn’t mean your investments aren’t performing well, or that you (or your financial planner) necessarily made any mistakes in establishing your asset allocation strategies. You may need to rebalance in response to market fluctuations that decrease or increase the value of certain types of assets. Possibly, you could need to rebalance because you’ve done everything right — buying investments when their cost is low and selling after a price increase can maximize your earnings but also push your asset allocation off target.
Investors can find the concept of rebalancing challenging because the process often involves reducing the amount in asset categories that are doing well and increasing asset categories that are not performing as well. It is a mechanized way to “buy low and sell high” at the margins. It is hard, though, to buy when the news is likely to be discouraging or sell when the trend seems to be pushing ever-higher. Self-guided investors often find themselves emotionally invested in their portfolio choices, and so find the concept of rebalancing difficult to put into practice.
Independent financial advisers can be more objective about your money, so can help disengage emotions from investing decisions, helping you can make the rebalancing decisions that will help your portfolio continue to prosper.
The strength to endure
Of course, rebalancing isn’t the only approach to managing asset allocation in an investment portfolio, but we do believe it’s an important one for most investors. Others such as stop-loss—selling an investment when the stock price falls in order to “stop” your losses—require investors to attempt to predict market timing and movement. Studies find that these approaches fail to deliver consistent positive long-term results.
While periodic rebalancing does involve the trading fees and possible tax costs of placing trades, when implemented in a diversified portfolio, rebalancing is a key tactic for long-term successful portfolio management.
To help guide your portfolio’s structure, you need to know how much risk you can be comfortable with having when it comes to your money.
What’s your personal level of investment risk tolerance?