Asset allocation consists of identifying appropriate investments from the major asset classes to build an investment portfolio. Let's look at some of the characteristics of each major asset class:
Stocks. Companies sell shares of their stock to raise funds for their operations. Stocks are also called equities since they represent an ownership interest in the company. You buy shares of stock using a brokerage account. Some companies use a stock purchase plan to sell shares directly to investors.
You can also buy shares of stock mutual funds. Mutual funds are pass-through investments, which means that the fund is responsible for passing along most of its income to shareholders.
Of the three major asset classes, stocks have the greatest amount of risk since they have higher potential returns than bonds or cash. According to data from Ibbotson Associates' 2007 Yearbook, stocks -- as represented by the S&P 500 index -- averaged an annual rate of return of 10.4 percent over the 81 years ended in 2006.
Bonds. Companies, governments, municipalities and government agencies sell bonds to raise funds. Bonds are similar to an IOU: the issuer borrows money at a contracted interest rate and period and repays the bonds at the end of the bond term.
Bonds are also called fixed-income securities since the coupon rate is often fixed. This predictability in cash flows provides more certainty to investors than stock dividends, which are not contracted. You buy bonds using a brokerage account or you can buy bond mutual funds.
Generally, bonds generally have less risk and lower returns than stocks. (Some bond categories offer a higher rate of return in exchange for greater risk. Junk bonds, for example, have historical returns on par with stocks but have a greater chance of defaulting than government or agency bonds.)
According to data from Ibbotson Associates, intermediate-term bonds averaged an annual rate of return of 5.3 percent over the 81 years ended in 2006.
Cash. The third major asset category is cash. Cash includes cash-equivalent securities (also called "near cash") such as savings accounts and deposits, CDs, Treasury bills, money market accounts and money market mutual funds.
Cash investments are the most liquid and least risky of the three major asset classes. As a result, cash investments have lower historical returns than stocks or bonds. According to Ibbotson Associates, cash (as represented by Treasury bills) averaged an annual rate of return of 3.7 percent over the 81 years ended in 2006.
Although most asset allocation decisions are based on the major asset classes, other asset classes exist. These alternative investments include real estate, private equity, futures, options, foreign currencies and precious metals. Each of these investments has unique risk characteristics that should be fully understood before investing in them.
This information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.