Understanding Asset Allocation

Asset allocation means dedicating certain percentages of your holdings to broad asset categories like stocks, bonds, real estate and cash as a way to achieve your financial goals while managing risk.

This strategy can work because different categories behave differently. Stocks, for instance, offer potential for both growth and income, while bonds typically offer stability and income. The benefits of different categories can be combined into a portfolio with a level of risk you find acceptable.

Although asset allocation plans will be different for different investors, a hypothetical asset allocation can be illustrated with a pie chart like the one below.

Market history tells us that asset categories perform differently from one year to the next. Bonds may post the best returns one year only to be outpaced by stocks the next year. Or real estate may be the hot category for a while and then go flat as another category heats up.

This is all easy to see when looking at historical returns. However, predicting which asset category will do best in any given year is very difficult. For that reason, it can make sense to divide investments among asset categories to provide some exposure to the winning categories as they rotate over the long term.

Asset allocation helps investors balance the returns they want with an acceptable level of risk. Your asset allocation should be based on your investment goals, time frame and comfort with volatility.

In retirement, you might want to emphasize bonds and cash for income and stability. But don't overlook stocks, because you need to keep up with inflation.

If you won't need your money for 25 years, a financial advisor might recommend an asset allocation of 100% stocks. That wouldn't mean investing in only one stock. You'd still want your portfolio to be diversified across a variety of stocks.

After your allocation percentages have been decided for broad categories, you can take asset allocation a step further by diversifying among classes within the categories. Keep in mind, however, that diversification does not assure a profit nor protect against loss in declining markets.

Choices For Diversifying Within Asset Categories
Examples of stock classes	Examples of bond classes
Large Cap Small Cap Growth Value International	U.S.Treasury Corporate Municipal

When comparing different investment strategies over the past 20 years, investing across asset categories has helped reduce overall portfolio volatility, while helping to avoid market-timing pitfalls.

Consider the following 3 scenarios, illustrating different investing strategies. While these returns can't guarantee future results, asset allocation, in this particular example, was the most successful strategy during the noted time period.

Does Asset Allocation Really Work? Returns on $10,000 invested annually in stocks and bonds 1989–2008
Strategy	Average Annual Return
Chasing the winners Investing in previous year's best-performing asset class
Chasing the losers Investing in previous year's worst-performing asset class
Allocating among asset classes Investing evenly across asset classes

Source: © 2008 Morningstar. Index scenarios above include large cap stocks, represented by the S&P 500 Index; large cap growth stocks, represented by the Barra Citigroup Growth; large cap value stocks, represented by the Barra Citigroup Value; small cap stocks, represented by the Russell 2000 Index; small cap growth stocks, represented by the Russell 2000 Growth Index; small cap value stocks, represented by the Russell 2000 Value Index; foreign stocks represented by MSCI EAFE Index; and bonds, represented by the Barclays Capital U.S. Aggregate Index. This illustration assumes that these indexes are reasonable representations of asset classes and their returns. However, investment manager performance relative to the different asset class indexes has varied widely during the past 20 years.

While an asset allocation plan eliminates a lot of the day-to-day decisions related to owning a portfolio of investments, it doesn't eliminate the need to review your portfolio regularly with your financial advisor. Monitoring and rebalancing your asset allocation can help make sure you stay on track to meet your goals.

Hypothetical Asset Allocation