Asset allocation is a form of diversification but distinct from diversification within an asset class such as stocks. When you diversify within asset classes you avoid putting all your eggs in one basket. Diversification of asset class avoids having only eggs. That is, you do not want only stocks or only real-estate or only whatever.
The solution is to invest in diverse classes of assets that are not highly correlated. The desired result is that some asset class will always be doing well. The downside; when assets are not highly correlated, they probably will not all do well at the same time. More importantly, they will probably not all do poorly at the same time.
Consider the following investing rules attributed to investing legend Warren Buffet – There are 2 rules in investing: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1
The primary breakdown of asset classes (equities, fixed income, and cash & cash equivalents) can be further broken out as:
Notice that mutual funds are not in the list. This is because mutual funds are packaged as collections of assets. For example, you can get a bond fund, a fund representing stocks in an emerging market, or a silver fund.
An interesting development in mutual funds is the emergence of lifestyle or lifecycle funds – funds that hold an asset mix appropriate to age and other factors.
In general, the mix of assets (by class) that are appropriate for you is a function of your age – or more accurately, the number of years you have left to contribute to or be supported by the assets. As we age, we take less risk since we have less time to recover from the adverse effects of risk-taking.
But it is more than just age. Your personal allocation should also consider your risk tolerance, investment purpose, and expected standard of living.
If your broker does not offer an asset allocation tool, consider one offered on the internet. In any case, be certain you understand the model assumptions made in the tool.
For additional information, a good place to start is the comprehensive article The Beginners Guide to Asset Allocation offered by the US Securities and Exchange Commission (SEC).
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Updated Mar 2016