If you like putting all your eggs into one basket, you won't be interested in asset allocation. But if you worry about taking risks, if it makes you nervous to bet everything on one flip of a coin or the draw of a single card, pay attention.
Asset allocation refers to putting your investments into different classes of assets. For most of us ordinary citizens, that means putting some of our investments into common stocks, some of our investments into bonds, and leaving a bit in cash, usually in what is referred to as a money-market fund.
The idea is that we all have different appetites for risk. Some of the difference may just be due to the kinds of people we are -- to our personalities. But some of the difference in our desire to take risks has to do with our timetables for spending our assets. Obviously, as I get closer to retirement and imagine wanting to start spending my assets, I want to take fewer risks with them than I was willing to 30 or 20 or even 10 years ago. Other investors may not want to take risks because they want to be sure they have enough for a down payment on the house they want to buy. Still others may soon be facing huge tuition bills for their college-bound children. This would definitely not be the right time for them to take big risks.
When we put some of our assets into stocks, some into bonds, and keep some in cash, we are betting that these asset classes will perform differently over time. Bonds may go down, but stocks will go up. So through asset allocation we can reduce the volatility of the returns we get from investing -- we can smooth out the ups and downs.
In fact, that is just what has happened during the recent market turmoil. As stock market values plunged over the last year, the Fed has been cutting interest rates. As interest rates have fallen, bonds have increased in value. In fact, as stock prices have fallen, bond prices have really boomed. Investing in bonds was a lot smarter than investing in stocks over the last year.
Of course, more sophisticated investors make many more fine distinctions. They choose among different kinds of stocks: large cap, which stands for large capitalization, that is, huge companies with large stock market values; medium cap; and small cap. They may buy technology or non-technology stocks. They may buy stocks of companies that are growing rapidly, or stocks that many investors have been ignoring. They may invest in bonds from governments -- the U.S. or foreign -- or corporations. They may buy bonds that mature in the near term, or only in 30 years.
The way to go about allocating your assets is first to figure out what you own -- what in fact you are investing in now. Then figure out whether or not you have enough diversity in your investments given the spending schedule you might have and given your appetite for risk.
To hear Professor Marvin Zonis, from the University of Chicago Graduate School of Business, talk about asset allocation, check out our One Minute MBA video clip. Just click the appropriate connection speed in the video box on the right column of this page.