What is an Asset Allocation, and Why Do I Need One?

To get the most out of this article, you'll need to have a solid understanding of asset classes. If the phrase "asset class" is Greek to you, read the article titled "What are Asset Classes" in this series first, then come back here. If you've got asset classes down, read on!

"Asset Allocation" is simply a term that describes the types and amounts of assets you own. When you start investing, you'll have to choose from various types of investments, including stocks, bonds and real estate, and you will have to decide how much of each one you want to own. That's asset allocation! Simple enough, right?

The problem most beginning investors have is that they have no idea how much of each type of investment they SHOULD own. Unfortunately, that's not such an easy thing to explain. Asset allocation is a personal decision, because everyone has a different tolerance for risk. There are plenty of guidelines floating around out there, like "60% equities and 40% fixed income is a good balanced portfolio," or "your equity percentage should be equal to 110 minus your age," but quite honestly those suggestions are far too vague to be of much help to anyone.

Your asset allocation should take ALL of your assets into consideration, not just your retirement accounts. If you have a taxable investment account, include that as well. Even your savings accounts and checking accounts should be considered (if you keep a large percentage of your money in them). Some people also consider home equity as a part of their asset allocation, although if you have a lot of equity in your home that can make your ratio of equities to bonds to real estate look a little unbalanced. For my purposes, I find it's best to ignore home equity and just look at my investment accounts.

The best way to figure out the asset allocation that's right for you is to break the question down into 2 parts. First, you want to look at the overall ratio of equities to fixed income, which is going to be the biggest factor in determining your risk level. As I said above, 60% equities to 40% fixed income is the industry standard for a "balanced" asset allocation, but that doesn't mean it's the right balance for you. The younger you are, the more time you have to ride out the bumps of the stock market, which means that a 25-year-old investor might want a very large percentage of stocks in his or her asset allocation to increase returns (while accepting the tradeoff of increased risk). Conversely, a 90-year-old investor may want to have 0% in stocks, to protect his or her principal. Subtracting your age from 110 can be a helpful tool in deciding this percentage, but it's not a hard and fast rule. There are also risk-tolerance calculators available on the web that can help you decide.

Once you've decided what your equities to fixed income ratio should be, it's time to break each of those categories down further. Within each portion, you need to make sure that you are properly diversified, which simply means that you own a piece of each sector of the market. Since buying enough individual stocks to provide good diversification is nearly impossible, you'll use stock mutual funds to create your allocation. You might choose a large-cap domestic fund, a small-cap domestic fund and an international fund, and split your stock allocation evenly between them. You could diversify further and choose both a growth and value fund in each of those three categories. You could also add a real estate fund if you like, or leave out the international fund if you prefer only to invest in domestic companies. The choices are really limitless. There is a wonderful website, www.fundadvice.com, that can help guide you through the pros and cons of owning various asset classes. Apply the same ideas to the bond portion of your allocation, and voila! You've got an asset allocation that both suits your risk tolerance and is diversified across many sectors of the market.

Another excellent way for beginning or hands-off investors to make sure they have a good asset allocation is to buy a Target Retirement Fund or Lifecycle Fund as their ONLY investment. These funds are actually "funds-of-funds," meaning they're comprised of many different stock and bond funds that each focus on a specific sector of the market. When you buy a Target Retirement Fund, you're buying a large-cap, a small-cap, an international, maybe a real estate AND a bond fund, all in one. These funds are also customized so that the ratio of stocks to bonds decreases as you age, automatically decreasing your risk. For instance, the Vanguard 2040 Target Date Retirement Fund (which is targeted at people who will be retiring around 2040) currently has a 10% allocation to bonds. However, in ten years, the 2040 fund will have more like a 20% allocation to bonds. Therefore, people who invest in this fund in 2008 don't have to worry that their risk tolerance has changed in 2018 - the fund changes right along with them. It's a truly set-it-and-forget-it approach to asset allocation.

Developing an asset allocation may seem like a Herculean task, but there are many tools out there to help you. Check out the other series articles for more information about investing, retirement accounts and personal finance in general. Once you've set your asset allocation properly, all you have to do is keep saving, keep investing, and look forward to retirement!