What Is Asset Allocation?

April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.

Today's term: asset allocation.

In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.

But the term also refers to an investment strategy -- one that can reduce risk through diversification.

Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year. (It's worth noting, though, that long-term investors who held on regained those losses.) That was also a time of falling real estate values, and had you been a big property owner, especially in some particularly hard-hit regions, you'd have suffered a big blow, with our national housing market only recently starting to pick up again.

Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.

Cash's buying power tends to shrink every year, due to inflation. Given the inflation we've experienced between just 2000 and 2012, something that cost you $100 in 2000 would cost you about $132 today. Dollars stashed in a mattress are shrinking dollars.

Even dollars kept in savings accounts these days are problematic, given our low interest rates. If you're earning even 1 percent in interest, but the inflation rate is around the long-term average rate of roughly 3 percent, then you're losing ground by 2 percent annually. Bonds can offer a guaranteed return, but they too sport low interest rates today, and bond prices can fall over time, too.

Allocation in Action

There is no one-size-fits-all perfect asset allocation model. What's good for you might be less so for someone else, due to the current size of your nest egg, your risk tolerance, your years until retirement, and other considerations.

One thing that everyone should do, though, is rebalance their portfolio, to maintain the desired allocation. That's because over time, an allocation will likely change.

Imagine this simple example: If your assets are split equally between stocks and bonds, and over three years your bonds hold steady, but your stocks double in value, your allocation will no longer be 50-50. It will be 33-67, with stocks making up much more of the overall portfolio.

Some advisers may suggest rebalancing frequently, after minor changes. You needn't be that fastidious about it, as frequent selling and buying can generate unwelcome commission fees. But do keep an eye on your holdings and when any category has become meaningfully larger or smaller than you want, rebalance.

One Way to Allocate Your Assets

Tending to rebalancing is easier said than done, which is why target-date funds have grown more popular. These mutual funds are built and managed around a particular retirement date, and therefore rebalance their holdings over time, investing more conservatively as the "target" date approaches.

Keep in mind, though, that there's a lot of variation among these funds. Even with similar names, funds from different companies can give you dramatically different performance. Remember, too, to keep any target-date fund holdings in perspective by factoring in your assets that are held outside of the fund. You might think that you're all set, with half of your nest egg in a target-date fund. But if the other half of it is all in stocks -- or real estate or cash -- then your overall portfolio allocation is far from what the target-date fund is targeting.

However you do it, be sure to pay attention to your asset allocation. The stocks, funds, bonds, and investment properties you pick do determine your ultimate results, but so does your allocation.

Want to learn more? Take our course on investment strategies in the DailyFinance Learning Center.

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More money terms:
Net worth
Sunk cost
Opportunity cost

See all money terms to know