Asset Allocation: Fundamentals
Risk is an inevitable part of investing. The good news is that risk can be managed. Asset allocation can help you reduce risk and enhance the potential of meeting your investment goals, although it does not guarantee a gain or eliminate the possibility of investment loss.
What is asset allocation?
Asset allocation is the process of combining stocks, bonds, and cash in an investment portfolio. Doing so creates a mixture of assets, each of which reacts differently to changes in the economy and financial markets.
- Stocks (also referred to as equities): Have historically offered the best opportunity for long-term growth, but by assuming more risk and volatility, they have also produced a wider range of results.
- Bonds (also referred to as fixed-income): Have historically earned returns within a much more narrow range, indicating that they are less risky than stocks, but still subject to interest rate risk and other risks. Their investment returns historically have also been generally lower than equities.
- Cash: Offers the least risk, but also the least opportunity to grow an investor's money.
Combining all three types of assets in a portfolio manages risk by:
- Reducing exposure to a single asset class and its related risks.
- Giving the portfolio the potential to gain when each type of asset is in favor.
Learn more about diversification and how to choose asset classes for a portfolio.
What explains a portfolio's performance over time?
You may think that decisions about which individual assets to own and when to buy or sell them are the most important aspects of investing. However, according to two significant studies, the reality is that asset allocation policy has been responsible for determining more than 90% of a portfolio's performance variability over time. The choice of securities and timing of purchases and sales have a low impact on performance for long-term portfolios. This makes the asset allocation decision one of the most important decisions you will make as an investor.
Source: Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, January/February 1995.
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