Asset allocation–An overview
The combination of stocks and bonds in your retirement account is known as your “asset allocation.” An example of an asset allocation would be 50% stocks and 50% bonds, or 70% stocks and 30% bonds, or any combination thereof.
A good way to think about different asset allocations is in terms of the risk they carry. When we talk about “risk” in the world of investments, we are fundamentally referring to how much a given investment changes in value over time.
Some asset allocations can carry more risk than others (such as 100% equity), meaning they are more prone to shift up or down in value, but they may provide a better return over time. Other asset allocations may be more stable and less prone to large swings in value, but they might not grow in value very quickly. Since your needs will change over time (especially as you transition into retirement), your asset allocation will need to change as well.
Why would I use more Stocks or more Bonds?
Stocks, or equities, have historically offered the highest risk and highest returns. But not all stocks are the same. Large-cap stocks are less risky and small-cap stocks have more risk. Investors willing to deal with the volatility of stocks usually realize the best positive returns over time.
Bonds have historically had less volatility than stocks, but the trade off is that they offer more modest returns. There are some types of bonds that are riskier such as junk bonds and high-yield bonds. Investors with a short time horizon often keep their investments in bonds since they offer stability and regular income.
Many mid-career investors prefer riskier asset allocations that frequently shift in value, but have the potential to grow their account value substantially while they have non-investment income. As they get closer to retirement, these types of investors then transition to more conservative allocations.
Are there other factors that influence my asset allocation?
Yes, “time horizon” and, “risk tolerance,” are two main factors that will affect your asset allocation.
Your time horizon is the number of months or years until your financial goal. Investors saving up for retirement often invest in riskier assets since they have a long time horizon, while a parent saving for a teenager’s college education may stick to less risky investments since they have a shorter time horizon.
The second major factor influencing asset allocation is an investor’s risk tolerance. In other words, his/her ability and willingness to lose some or all of the original investment in exchange for greater returns. Aggressive investors may be willing to take on higher risk to get better returns, while conservative investors may stick with low-risk investments aimed more at capital preservation.