Asset allocation, or diversification, is the art and science of combining the three major asset classes - stocks, bonds, and cash - to reach an investment objective while managing risk. A review of the investment characteristics of these three asset classes is helpful to understanding the asset allocation process.
Stocks, or equities, represent part ownership in public companies. Ownership means enjoying the rewards of that company's profits and success and accepting the risk of that company's failure, or losses. A stockholder makes money by receiving cash dividends from the company and/or by obtaining capital appreciation if the stock is sold at a higher price than the original purchase price.
In contrast, bonds are issued (sold) by corporations, state and local governments or their agencies, the U.S. government, foreign governments, and federal agencies. Although each type of bond has its own characteristics, bonds, in general, are formal IOUs in which the issuer promises to repay the total amount borrowed on a predetermined date. In addition, the issuer will compensate the bondholder with, typically, semi-annual interest payments at a fixed percentage rate for the use of the money. The price of the bond will fluctuate during the holding period due mainly to changes in market interest rates relative to the bond's stated rate of return.
Cash, often invested in the form of money market funds, also represents loans, but over much shorter time periods - less than one year.
Historically, stocks have outperformed bonds, and bonds have outperformed cash. Stocks have also been more volatile than bonds, and bonds have been more volatile than cash.
There are three risks to consider when investing - inflation, volatility, and emotions. Asset allocation addresses each of these risks.
If your investment time horizon is 10 to 15 years or longer, inflation risk should be your greatest concern. Inflation is simply rising prices. Historically, inflation has caused prices to double about every 20 years. Another way to look at inflation is that your income today will have to double over the next 20 years just for you to maintain the same standard of living! Fortunately, you should be able to combat inflation by investing in stocks and bonds because, historically, they have significantly outperformed the rate of inflation over the long-term. However, when you invest in stocks and bonds, you should remember that you are also introducing volatility to your portfolio.
Volatility means that your returns can vary greatly over the short to intermediate term. Stocks display the most volatility, while bonds are less volatile and cash the least volatile.
Volatility cannot be eliminated, but it can be reduced through asset allocation. Because performance can vary significantly over the short term, by diversifying your investments among asset classes, you can both lower volatility and maximize returns. Additionally, the short-term performance of securities within an asset class can vary widely, so it's also important to diversify within an asset class to reduce volatility. For example, an allocation to stocks should be further diversified by style (growth and value), company size (small, mid and large capitalization), and geography (domestic and international).
The third risk is our own emotions. This trips many of us up because the three major asset classes each go through their own performance cycles. Returns will rise for a period, then fall, and then rise again. However, as humans, we tend to make decisions emotionally. For example, when we are very optimistic about the stock market - such as we were in December of 1999 - we want to buy, and that can often be the worst time to buy. And when we are very pessimistic about the stock market - like we were in October of 2002 - we want to sell, and that often can be the worst time to sell. This is often called the Greed-Hope-Fear Cycle. We buy "high" out of greed, hope our investment will recover after it has disappointed us for some time, then sell "low" later on as it continues to disappoint us out of fear we will lose most or all of our investment. Asset allocation removes the emotion from investing by forcing us to have a long-term commitment to all three major asset classes. This means always being invested in the asset class that is performing well today as well as the asset class that is performing poorly today because we do not know when their performance cycles will shift.
Asset allocation is a long-term investment management tool. Over the short term, asset allocation will not give you the best returns, because you will not have all of your assets in the best performing asset class. It also means that you will not have the worst returns either because you will not have all your assets in the worst performing asset class. However, over the long term, asset allocation should help you to both increase your returns and decrease your risks.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.