Asset allocation, the process of dividing your investments among asset categories, can help balance the potential risk and reward of your investments.

Studies by Ibbotson Associates, a Chicago-based research firm, found that about 90% of a mutual fund's return over time was based on how its assets were allocated. The specific investments you choose, and when you buy and sell them, account for only a small portion of your return.

Your portfolio generally should include various types of investments that are expected to perform differently during particular economic conditions. When you're diversified in this way, a decline in any single investment has less of an impact on your overall portfolio and may be offset by increases in other investments, though asset allocation alone cannot ensure against loss.

Plan Your Asset Allocation

It's important to know three things in planning your asset allocation mix:

  • Your Goals - Retirement, a college education, wedding, etc.
  • Your Risk Tolerance - Tolerance for changes in the value of your investment portfolio
  • Your Time Horizon - How long your investments will be working toward your goals

Choosing Your Investments

Next, consider the various types of investments available to you and their risks and rewards. Higher risk is associated with the possibility of higher reward and the inverse also is true. While it may seem attractive to chase the return of the latest hot stock, you're more likely to come out ahead with balanced investments in stocks, bonds and money markets.

  • For long-term growth, stocks are hard to beat. But stocks also carry the highest risk.
  • Many investors further diversify their portfolio by adding international investments. Although these investments may have the additional risk of currency fluctuations and potential political unrest, their presence in your portfolio can help offset the risks associated with volatile periods in domestic markets. However, a diversified portfolio does not ensure against a loss.
  • The prices of bonds-which essentially are loans to governments, agencies or corporations-generally fluctuate less than those of stocks, so bond investments are considered less risky than stocks. However, as interest rates rise, bond prices tend to fall.
  • Money market investments often provide reliable but smaller returns. Although such investments are not guaranteed, they can provide a relative degree of safety along with easy access to your money if needed.

Money Market Fund: An investment in the fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.

Many investors build an asset allocation mix using mutual funds in each category, rather than individual securities, which adds an additional measure of diversification and professional investment management.

Changing market conditions over time can throw your asset allocation off your intended track. Your allocation needs may also change as your goals change. Review your overall portfolio on an annual basis (or more often if there is a major change in your life) and rebalance your portfolio as needed.

Asset allocation takes some discipline, but the payoff in risk reduction can help protect your portfolio and ultimately, your personal financial goals.

This information is for educational purposes only and is not intended as investment advice.