What is Asset Allocation?

Have you ever noticed that street vendors often sell seemingly unrelated products - such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never - and that's the point. Street vendors know that when it's raining it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, it's a lot easier to sell sunglasses than umbrellas. By selling both items- in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.

If that makes sense, you've got a great start on understanding asset allocation and diversification.

Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.

  • Time Horizon - Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investments because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. On the other hand, an investor saving up for a teenager's college education would likely take on less risk because he or she has a shorter time horizon.
  • Risk Tolerance - Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In the words of the famous saying, conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush."

Why Asset Allocation Is So Important?

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to do average or poorly. By investing in more than one asset category, you'll reduce the risk of losing money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

The Magic of Diversification!

The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

Content from this article was provided by www.sec.gov - A beginners guide to asset allocation, diversification, and rebalancing. 

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