Asset Allocation Definition (Investopedia): Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time.
5th Grader Definition: Investing diversely so that your investments grow and you can one day retire! Investing in a manner which fits your goals, investment timeline, and risk tolerance. A.K.A. avoiding 100% bonds or cash; 100% of just about anything is usually the wrong long-term answer.
5 Problems To Avoid…
- Not checking your investments routinely (quarterly, semi-annually, annually) to ensure you’re invested in a way that matches your goals, timeline, and risk tolerance. Asset allocation and re-balancing your assets is a lifelong journey – try for annual reviews, at least
- Starting a new job, signing up for the 401K and getting the full company match like a boss, and then not checking where the money is automatically invested. Hopefully it’s NOT 100% invested in a bond fund returning 1-2% (that would be bad…).
- Using a standard asset allocation: You are unique. (1) Remember your needs and goals and (2) Average Joe will likely invest differently than a wealthy entrepreneur
- Thinking you need a lot of money to start investing – wrong… just start! Save 1% of your paycheck if that’s all you can afford. If you get a pay raise, then raise your savings.
- Thinking too much…
- THIS IS NOT VEGAS… your investment process should be boring and repetitive – not sexy
- Set up automatic investments from each paycheck
- Invest diversely: exchange traded funds (ETFs) and mutual funds give you a larger mix of stocks and bonds. This larger mix will help you avoid the “1 sexy stock you realllllly want” that may go up or down
Here’s 600,000 reasons why asset allocation freakin’ matters…
- Individual has 30-35 years until they reach retirement age
- 10,000 yearly investment for 35 years
- 6% annual growth is assumed for the ‘better-fit’ asset allocation (i.e. stocks and bonds mixed)
- 2% annual growth is assumed for the ‘poor-fit’ asset allocation (i.e. 100% bonds)
35 Year Outcome: 6% growth portfolio is valued at $1,114,000 while the 2% is valued at $500,000… your investment choices may make a HUGE difference.
Also interesting… Researchers at T. Rowe Price compared the returns of portfolios that varied from 100% bonds to 100% stocks with various combinations of stocks, bonds and cash. From 1985 through 2012, a portfolio of 60% stocks, 30% bonds and 10% cash would have returned 9.8% annualized—about 93% of the return of an all-stock portfolio, but with just 62% of the risk. Now that my friends is asset allocation to a T.