Asset allocation is the strategy of dividing an investment portfolio between different asset classes, such as stocks, bonds, and cash or cash equivalents. By adjusting the percentage of each asset class in a portfolio, investors can attempt to balance risk versus reward.
Asset allocation is not one-size-fits-all. It is a personal decision, dependent on the investor’s risk tolerance, investment time frame, and financial goals.
It will also likely change during different periods of an investor’s life. For example, investors with a long-term investment horizon may decide to take on more risk than those nearing retirement. Conversely, an investor with a short-term investment horizon may prefer to hold only highly liquid investments such as short-term bonds, money market funds, and savings accounts.
A short-term investment horizon is considered fewer than five years, while a medium-term investment horizon is typically considered three to 10 years. Finally, a long-term investment horizon is one lasting over 10 years.
The 3 Main Asset Classes: Equities, Fixed Income, and Cash/Cash Equivalents
Stocks, or equities, represent shares in ownership of a company. A heavier allocation to stocks may provide more opportunity for growth. In turn, stocks are also considered riskier assets than bonds or cash/cash equivalents.
Bonds, also known as fixed income, are debt securities representing a loan the purchaser (bondholder) makes to the issuer. Notably, bonds can be issued by companies or a government.
Additionally, bonds have a defined interest rate and duration. The bond will pay interest at regular intervals, such as quarterly, biannually, or annually, until maturity. At the time of maturity, the issuer repays the bondholder the original face value of the bond, plus interest.
Bonds may offer income and additional stability, as bonds are seen as less risky than equities. However, it’s important to note that all bonds, to varying degrees, carry credit risk, which is the risk that the bond issuer may default on payments. Different types of bonds have different risk profiles.
Finally, cash or cash equivalents are also important to asset allocation. Cash equivalents include any type of highly secure financial asset that can be converted to cash easily. Cash and cash equivalents are highly liquid assets typically offering the lowest rates of return in exchange for very low risk.
Other Asset Classes to Consider
While stocks, bonds, and cash/cash equivalents are generally considered the three main asset classes, investors can potentially enhance their portfolios by considering alternative assets. These might include commodities, cryptocurrencies, options, futures, and real estate, among others.
These alternative assets may be more volatile and carry more risk than the three main asset classes, requiring a deeper knowledge and understanding of how these products operate. On the other hand, they also have the potential to enhance portfolio returns and diversification, making them worthy of consideration for some investors.
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