Asset Allocation

Asset allocation describes how assets are divided among different asset classes, such as equities, fixed-income assets, and cash and its equivalents. The goal is to balance risks and rewards based on financial goals, risk tolerance, and investment horizon.

There’s no particular asset allocation that’s appropriate for everyone, but it is a critical decision. Diversification within an asset class is done only after deciding how to divide investments among asset classes (e.g., stocks, bonds, cash equivalents). How much one saves, and asset allocation, largely determines investment results. This assumes that one invests within their risk tolerance/capacity. Cognitive errors common to humans influence financial choices. For asset allocation, being swayed by market volatility, overconfidence, sunk-cost reasoning, or loss aversion can lead to poor choices that can torpedo a good asset allocation formulation. Incorporating risk tolerance and risk capacity into a plan generally leads to a long-term approach that best aligns with stated goals.

One of the drivers of asset allocation is the need to asset/liability match.  Someone saving to buy a new car in the next year should invest savings for the car conservatively (e.g., low volatility instruments such as high yield savings accounts, certificates of deposit, and/or short-term bonds). Individuals saving for retirement decades away should invest most of their retirement accounts in stocks if they can psychologically tolerate the volatility. This is because of higher projectedd returns with time to ride out the market’s relatively short-term fluctuations.

Note that what works for one person might not work for another. Personal finance is personal, so there is no such thing as an asset allocation model that is optimal for everyone. Good asset allocation varies by individual and can depend on various factors such as age, goals/financial targets,and  risk tolerance.

If you need assistance with determining an asset allocation model for your particular situation, please contact us.