Asset Allocation: How and Why It Works

By Markets Fool.com

Asset allocation means strategically investing your funds in a blend of asset types in order to reduce risk, allow your portfolio to grow, and meet your particular investing goals. This is often referred to as diversification, and it's one of the most fundamental and important investing strategies.

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The magic lies in the combination of the assets that make up a portfolio. With asset allocation, you use different assets' varying risk-reward profiles to create a portfolio that will provide the returns you need without carrying more risk than you can tolerate.

Asset types
Although it's not appropriate for all investors, the traditional rule of thumb calls for a combination of stocks, bonds, and cash reserves. However, each of these asset classes has multiple subcategories with greater degrees of specialization. For instance, stocks can be categorized based on the size of the underlying company:

Stock Classification*

Market Capitalization

Large-cap stocks

At least $10 billion

Mid-cap stocks

Between $2 billion and $10 billion

Small-cap stocks

$2 billion or less

*Note: There are no agreed-upon parameters for these classifications; they are open to interpretation, and they change over time. The figures given above are commonly used to describe each category.

Stocks can also be categorized as growth- or value-oriented. A growth stock is a company in the growth phase of its life cycle, when its stock is expected to be fast-growing but volatile. Think 3-D printers and up-and-coming biotechs. These sorts of high-octane stocks are more risky, but over time, they have the potential to multiply your investment many times over. They generally don't pay dividends because they're reinvesting profits in the company's operations in an effort to grow, grab market share, and become an industry dominator.

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Meanwhile, a value stock is a mature, established company that trades for a lower valuation than its competitors. Think of industry behemoths like General Electric. The combination of a stable business model and a bargain stock price makes these stocks relatively safe, though slow-growing. Value companies are known for returning profits to investors in the form of dividends due to their lack of growth prospects.

Meanwhile, bonds can be classified based on the degree of risk they carry, which you can see reflected in a bond's credit rating (see Moody's credit rating system). When it comes to issuance (bond issuer), bonds are broadly categorized as corporate bonds, government bonds, or municipal bonds.

Government bonds are issued by the federal government. Because they are backed by the full faith and credit of the U.S. government, they come with very little credit risk. These types of bonds serve mainly to protect principal. Municipal bonds are issued by state and local governments. In addition to providing general fixed income exposure, municipal bonds are exempt from federal taxes; this particular tax benefit can make these types of bonds appealing to investors in higher tax brackets. Corporate bonds are issued by private companies and come with the investor protections only that company can provide. These bonds generally provide higher yields than municipal and government bonds, though they come with a greater degree of credit risk. A healthy mix of government, municipal, and corporate bonds can help achieve a portfolio's fixed-income objectives.

Bond Classification

Issued by

Corporate bonds

Corporations/private companies

Government bonds

U.S. federal government

Municipal bonds

Municipalities; state and local governments and agencies

Rebalancing
Once you establish your asset allocation and invest accordingly, you should monitor your portfolio regularly -- say, once per quarter -- and make any adjustments needed to bring your asset allocation back to your target. This is called rebalancing.

As an example, let's say 60% of your portfolio is allocated to stocks, 30% is in bonds, and 10% is in cash. If your stocks have a rip-roaring quarter and swell to 67% of your portfolio, then suddenly your portfolio is "overweight" stocks, meaning this asset class now comprises a larger percentage of your portfolio than you intended it to. Meanwhile, your portfolio will be "underweight" bonds and cash. In this case, you may want to sell some winning stocks and put some of the proceeds into bonds and cash so that balance is restored to your portfolio.

Cash reserves play an important role in any well-diversified portfolio. Cash can serve as a protective cushion during times of market volatility and unexpected gyrations. It adds to a portfolio's liquidity and stability. It can also be your best friend when you encounter buying opportunities.

In addition to keeping your portfolio aligned with your investing goals, rebalancing your assets forces you to sell high and buy low, which is a must, assuming your goal is to make money.

To reap the benefits of a properly allocated portfolio, it's important to stick to your investment objectives. Markets are volatile and often unforgiving, which is why asset allocations should always be chosen strategically and with a goal in mind. Through rebalancing, we maintain healthy investment habits that remove the human element of emotion, which is hazardous to our returns. Asset allocation is always a prime consideration in professional portfolio management, and it should always play a part in your investment decisions.

The article Asset Allocation: How and Why It Works originally appeared on Fool.com.

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