Investing can be a daunting task, especially if you’re not familiar with the terminology and strategies used by investors. One of the most important concepts you need to understand is asset allocation. In this article, we’ll explain what asset allocation is, why it’s important, and how to create a well-diversified investment portfolio.
What is asset allocation?
Asset allocation is the process of dividing your investments among different asset classes such as stocks, bonds, cash, and real estate. The goal of asset allocation is to create a diversified portfolio that balances risk and return. By spreading your investments across different asset classes, you reduce the risk of losing all your money in one investment.
Why is asset allocation important?
Asset allocation is important because it can have a significant impact on your investment returns. Studies have shown that asset allocation accounts for more than 90% of the variation in a portfolio’s returns. This means that selecting the right mix of assets is more important than individual stock selection or market timing.
Asset allocation can also help you manage risk. By diversifying your portfolio, you can reduce the impact of any one investment on your overall portfolio. For example, if you invest all your money in one stock and that stock performs poorly, your entire portfolio will suffer. However, if you have a well-diversified portfolio, the poor performance of one asset class may be offset by the good performance of another.
How to create a well-diversified investment portfolio
Creating a well-diversified investment portfolio involves three steps: determining your investment goals, selecting your asset allocation, and choosing specific investments.
Step 1: Determine your investment goals
The first step in creating a well-diversified investment portfolio is to determine your investment goals. What are you investing for? Do you want to save for retirement, a down payment on a house, or your child’s education? Once you know your investment goals, you can determine your investment time horizon and risk tolerance.
Step 2: Select your asset allocation
The second step is to select your asset allocation. This involves deciding how much of your portfolio you want to allocate to each asset class. There are several factors to consider when selecting your asset allocation, including your investment goals, time horizon, and risk tolerance.
One common rule of thumb is to subtract your age from 100 to determine the percentage of your portfolio that should be invested in stocks. For example, if you’re 30 years old, you would invest 70% of your portfolio in stocks and 30% in bonds. This rule of thumb is just a starting point, and your asset allocation should be customized to your individual circumstances.
Step 3: Choose specific investments
The third step is to choose specific investments that fit within your asset allocation. There are many different types of investments, including individual stocks, mutual funds, exchange-traded funds (ETFs), bonds, and real estate. When selecting specific investments, it’s important to consider the fees, risks, and historical performance of each investment.
Conclusion
Asset allocation is a crucial part of investing. By diversifying your portfolio, you can reduce risk and potentially increase returns. To create a well-diversified investment portfolio, you need to determine your investment goals, select your asset allocation, and choose specific investments. Remember that your asset allocation should be customized to your individual circumstances and should be reviewed periodically to ensure that it still meets your investment goals.
