Most people have heard the term asset allocation even if they aren’t investors themselves. It’s a term that gets used frequently when planning your finances and investments so it’s a great idea to have some idea of what it means and how it might apply to you – even if you don’t own any investments at all!

What is Asset Allocation?

Asset allocation refers to the relative amounts of various assets that you own. For example Susan might own a house, a car, have a 401k with her employer and keeps some cash in the bank. What is her asset allocation?

If her assets have the following values:

  • house – $200k
  • 401k – $40k
  • car – $10k
  • cash – $10k

then their total assets is equal to $260,000. Normally you talk about asset allocation in terms of percentages of the total – so for our example Susan would have the following asset allocations:

  • house – 77%
  • 401k – 15%
  • car – 4%
  • cash – 4%

From these numbers it is clear that this person has a high weighting of real estate at 77% (their house) and a low weighting of cash (only 4%).

An important term to learn is asset classes – these are assets that are similar enough that you would group them together when talking about asset allocation. For example if you own two different stock mutual funds then you might just lump them together in your “stock” allocation.

What about Investment Asset Allocation?

Ok, so now we’ve covered what asset allocation is and how it applies to any kind of assets we might own – let’s take a look at investment asset allocation.

One of the key things to know about asset allocation with respect to your investments is that there are different levels from general to specific. It’s easy to get confused when someone asks you a very specific asset allocation question like “How much do you have in junior oil players?” when you can’t even remember the name of your investment company! The best way to analyse your asset allocation is to look at your portfolio at a very general level and then only worry about the specifics later on if you feel it is necessary.

The most general investment asset classes are stocks, bonds and cash. These don’t have to be owned directly – most people own stocks and bonds indirectly through a mutual fund or exchange-traded-fund (ETF).

Some general investment asset allocation examples

Here is an example of a general asset allocation:

  • Stocks – 70%
  • Bonds – 20%
  • Cash – 10%

In this case, the investor has a high (70%) allocation in stocks which indicates that they are a fairly aggressive investor since stocks usually go up in down more in value than bonds and cash.

If you were to look at that investor’s account statements, they would probably own several different investments that fall under the “Stocks” category – since we are just looking at the general asset allocation we would just lump all the “stock” investments together.

Here is another asset allocation example of a more conservative investor:

  • Stocks – 30%
  • Bonds – 50%
  • Cash – 20%

In this portfolio, there are a lot less stocks and more cash so this portfolio probably won’t be as volatile as the more aggressive example.

What is the Point of Asset Allocation?

The main purposes of figuring out your asset allocation are:

  1. Knowing what you are invested in. If you have 90% cash and CDs then your portfolio is very conservative and you are unlikely to lose much money. You are also very unlikely to make a lot of money. If this is not what you want then it’s time to make some changes.
  2. Diversification. If you own a lot of different mutual funds then it is hard to know what they all contain. By going through and figuring out what types of industries and stocks they invest in – you can see if your portfolio is diversified or if you have 90% of your portfolio in junior oil stocks.
  3. Investment time horizon. If the money in your investment account is intended for retirement and that is many years away – then you can have a higher allocation to stocks since you have time to make up any losses. If the money is for next year’s vacation – then it better be in something very safe such as CDs.

Photo by borman818.