If you have an investment portfolio, like a 401(k) from work or a brokerage account that you manage on your own, it may be made up of a range of different assets: stocks, bonds, and maybe even some cash in certain accounts. How you divvy up your assets in your portfolio is referred to as asset allocation. Pretty straightforward definition, right?
But there’s more to asset allocation than just splitting up your stocks and bonds any which way. It can be a factor in your investment strategy where you – and we’re going to borrow from the official definition here – allocate, or, divide your securities based on factors like your risk tolerance, time horizon, and even your money goals. And every so often, you might shift the percentage of your assets (aka rebalance) to make sure the breakdown still meets the intended mix as well as your needs.
Whether you’re a new investor or an old hand, we’ll review some things you should know about asset allocation and rebalancing, and how the two factors could play a role in your investment portfolio.
So…what is asset allocation?
We gave you a brief explanation above, but in case you want a bit more information, let’s dive in with an analogy.
If you’ve ever made a weekly grocery list and divided it up by different types of foods you need to purchase for the week’s meals, you’re already dabbling in asset allocation! Perhaps you set aside a certain percentage of the budget for vegetables, a certain percentage for food staples like bread, butter, eggs, and milk. You’d figure out how much you’ll need to spend on each food group based off the meals you’re planning to prepare that week.
Asset allocation works in a similar way, just swap the food for securities in your investment portfolio. Asset allocation is basically how your portfolio is divvied up amongst various asset classes, including most broadly stocks, bonds, and cash. And when you nail down an asset mix that fits your goals, that becomes your target asset allocation, that is, the breakdown (say stocks versus bonds) of your portfolio.
A financial advisor can help you determine what asset allocation makes sense for you depending on your individual money picture.
As you might know, different asset classes could perform differently. So one asset class could suffer some losses while the other could be climbing higher. If your portfolio moves away from your target allocation, you can shift it back to your more ideal mix (more on that later).
Another good thing to know: your target allocation can change. For example, as you get closer to retirement and become more conservative with your investments you might want more bonds than stocks in your portfolio, so you’ll want to periodically revisit the mix to see if it’s worth tweaking.
Asset allocation vs diversification
Asset allocation sounds a whole lot like diversification. If your portfolio has a mix of different assets, that means it’s diverse, right?
Yes and no. Even if your money is allocated across different asset classes, that doesn’t guarantee a diversified portfolio. For instance, if you have 60% of your portfolio allocated to stocks, but all of those stocks are from large cap companies, you could have a diverse portfolio but still not be diversified within specific asset classes.
While asset allocation can get you started, diversifying within the asset classes is what can get you to the truly diversified portfolio you may be after.
What should my asset allocation be?
We’ll be honest: there’s no right answer here! Your target allocation will depend on a few different factors.
- Age: Some folks figure out their asset allocation based on age – investors that are further away from retirement might have more stocks than bonds in their portfolios, but might shift to more bonds as they get closer to their second act. For retirement accounts, you could consider a formula for determining how much you should invest in stocks based off your age: 100 – age. The answer would be the percentage of stocks in your portfolio. So if you’re 35, you could aim to have 65 percent stocks and 35 percent bonds. Of course, this isn’t a hard and fast rule, but just one of many asset allocation strategies.
- Timeline: If you have a lot of time to work with, say 20 years, you might choose a more stock-heavy portfolio mix, since you have time for them to earn and can weather temporary dips in the market. If you need your money within the next few years, you might opt for more bonds since you won’t have as much time for your stocks to recover if there’s a dip in the market.
- Risk tolerance: If you’re more risk averse, it might be a good idea for your percentage of bonds to be higher than your percentage of stocks, since stocks are typically more volatile than bonds. If your risk tolerance is high, on the other hand, you’d likely want to invest more heavily in stocks than bonds, in the hopes of higher returns.
Good to know: your asset allocation can also vary across accounts. If you’re a few decades away from retirement, your IRA might have more stocks than bonds. On the other hand, an investment account that you’re using to save up for a down payment in the next few years, may be more bond-based.
Figuring out the right mix of assets might sound like a lot of work, but remember that you don’t have to go at it alone! A financial advisor can help you determine what asset allocation makes sense for you depending on your individual money picture.
What is rebalancing and why does it matter?
Rebalancing is bringing your portfolio back to your target allocation. You’ve probably seen how shifting markets can change the balance of your accounts. Based on how the market moves, it’s not guaranteed that the original way you divvied up your stocks, bonds, and other assets will stay that way indefinitely – some assets will do better at times than others, and vice versa.
Let’s say that you decided that the best allocation for your risk tolerance and goals is 50% stocks and 50% bonds. However, let’s also say based on market activity, your stocks start outperforming your bond holding. Eventually, that 50/50 allocation might shift, and your portfolio now looks more like 65% stocks, 35% bonds. While that means your stock holdings have been performing well, you might consider rebalancing your portfolio to bring it back to your target allocation