Smart investors recognize the importance of owning investments that don’t move in lock-step with each other, but rather perform differently over time. Why? Because over time, we expect the stock market to increase in value, albeit with short-term, occasionally severe, fluctuations. So, ideally, we would like to own an investment that increases in value when the stocks we own decline, which would smooth out the variability of our portfolio’s returns.
Historically, there have been several asset categories, or “asset classes”, that exhibit this relationship: stocks and bonds, US stocks and international stocks, large cap stocks and small cap stocks, etc. Over time, the strength of the correlations between the returns on these asset classes has varied.
Asset allocation is one of the most basic and important concepts in investing. It refers to the strategy of dividing your investments among different asset classes – such as stocks, bonds, real estate, cash, and cash alternatives.
Your asset allocation is the primary determinant of how risky your portfolio is. To the extent you include a higher percentage of risky asset classes – like stocks – in your portfolio, your returns will vary more from day to day, month to month, and year to year. But – over time – you can expect higher returns.
However, it’s important to note that a suitable asset allocation doesn’t ensure that you’re appropriately diversified. If you’ve determined that you should have 60% of your portfolio in stocks, you shouldn’t invest the full 60% in one or even a few stocks. Within each asset class, you should own as many securities as is reasonably possible. This eliminates the risk that one underperforming investment can damage your portfolio.
When done properly, determining an appropriate asset allocation will ensure that your portfolio is correctly positioned on the risk-return spectrum, while adequate diversification across and within asset classes will insulate your portfolio against suffering losses all at once.
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