Asset allocation is the process of dividing your money among several investment categories, called asset classes. An example of an asset allocation is 50% stocks, 30% bonds, 10% real estate, and 10% cash assets. The objective of asset allocation is to lower your investment risk by reducing portfolio volatility. Losses in one investment category are often offset by gains in another.
Research has shown that asset allocation is a major factor that affects investment performance. It is not what specific stock or bond you invest in that matters the most over time, but, rather, the fact that you have money in different asset classes. These studies have been repeated numerous times, by different researchers, with similar results.
Various factors should be considered when determining a personal asset allocation strategy. They include your investment objectives, time horizon, and the amount of money you have to invest. Other important factors are your risk tolerance and investment experience, age, and net worth.
The downside of asset allocation is that a diversified portfolio never earns as much as the "hottest" asset class at the time. This is because only a portion of your money is in that asset class. Of course, nobody knows in advance what the "hot" asset class of a given year will be, so this information can only be viewed in hindsight. Major asset classes include large, medium, and small company growth stocks; large, medium, and small company value stocks, foreign stocks from both developed and developing countries; domestic and international bonds; real estate investments; and cash assets such as certificates of deposit and money market mutual funds.
Remember to periodically recalculate asset allocation percentages and to rebalance, where necessary. Rebalancing means returning to your original asset class weightings and can be accomplished by either selling existing securities in an over-weighted asset class or putting new deposits into an under-weighted asset class. Some investment companies will even rebalance your portfolio for you on a regular basis (e.g., annually, on your birthday) if you request this service.
Use the asset allocation worksheet to calculate your current asset class weightings in non-farm investments. Simply replace the letters in the row placeholders with a description of your actual investments and list their current value (example: IRA Account, $20,000). The spreadsheet will total your assets in each of the three categories (cash, fixed-income, and equity assets) and calculate the percentage weighting for each asset class.