How To Understand Asset Allocation

Asset allocation is nothing more than diversifying your investments so as to reduce your portfolio’s volatility.  While not bulletproof, it remains the most common – and in most cases, most appropriate – investment strategy for middle-class investors.

Different investments are affected differently by different market conditions.  Many bonds, for example, increase in yield or value when stock prices drop, and stocks of different sized companies perform well under different market conditions.

Asset allocation seeks to reduce investor risk by harnessing this variation in performance.  Investing in a variety of vehicles, according to the theory, reduces the risk inherent in any one vehicle.  Ideally, any losses in one area of the investor’s portfolio are offset by gains in another area.

The exact mix of investments varies by age and portfolio size.  The closer the investor gets to retirement, the more conservative (subject to less fluctuation in value) his allocations should be.  An investor with a large portfolio, however, may be able to consider more aggressive or exotic investments, as he presumably can afford to assume the increased risk.

The 2008-2009 financial crisis demonstrated that asset allocation is not a foolproof investment strategy.  Stocks and bonds dropped in value across the board and many investors, particularly those approaching retirement age, suffered devastating losses in value to their portfolios because they were overweighted in stocks or stock-based investments.

Another knock on the strategy is it can be difficult to actually follow.  Investors approaching retirement, who under the strategy should have been shifting to a more conservative allocation, sometimes opted instead to chase the higher returns of riskier investments and thus suffered far heavier losses in last year’s crash.  Especially for retirement and college savings accounts, it is important to shift to less volatile investments the closer you get to withdrawing the funds.

The advantages of asset allocation were oversold by the industry, to the extent that it bred complacency on the part of both industry and investors.  As so many have learned, however, no single investment strategy is a foolproof formula for automatic, guaranteed returns.  Taking an active stance in learning the ins and outs of your different investment options and in monitoring the makeup of your portfolio, is a requirement for all markets.  In an imperfect financial world, however, the benefits of the diversification to be had through asset allocation continue to outweigh the risks.


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