Asset allocation

Asset allocation is the strategy you use to divide your portfolio among stocks, bonds and cash equivalents or the mutual funds that invest in those asset classes. Since each asset class carries different levels of risk and reacts differently to changes in the economy, the way you allocate your assets has a major impact on reaching your financial goals.

Why allocation works

• Historically, stocks have provided the strongest return of these three asset classes by doing extremely well in some years, although doing poorly in others
• Bonds have produced strong returns in some years and weaker returns in others, though the highs and lows tend to be less extreme than with stocks
• Cash equivalents usually provide the smallest, but most consistent, returns

In most years, though, one of these asset classes has a stronger return that the others.

For example, if interest rates are high and corporate earnings are weak, stock returns are likely to be disappointing. However, under those same conditions, bonds usually perform well.

If your portfolio consisted entirely of stocks in this situation, you'd face losses — potentially major ones. But if your portfolio included bonds, their earnings would have the potential to make up for, or offset, what your stocks lost. The key is finding a balance between asset classes that meets your particular needs.

The complication is that you never know, from year to year, which asset class will be the strongest performer and which will be the weakest. So the solution may be to always have some assets in each class.

Allocation models

You typically allocate a portfolio by assigning a percentage of the total to each of the asset classes you're including. For example, you might assign 60% of your holdings to stocks, 30% to bonds and 10% to cash — or almost any other combination.

Since each person has his or her own set of financial goals and risk tolerance, there's not one asset allocation model that fits everybody. The most important factors in determining your allocation are most likely to be the time you have until you want to pay for your goal and your comfort level with risk.

The impact of age

If you're young and you're investing for retirement, you may want to invest up to 80% of your principal into a diversified portfolio of stocks and stock funds for the potentially stronger return they offer. If they decrease in value in the short term, you have enough time to wait for a rebound. As you grow older, and closer to retirement, you'll probably want to reduce the assets you have in stocks to a smaller percentage of your total holdings.

These questions can help you find the right balance between risk and reward:

• What are your financial goals? Are you trying to earn enough for a new car, or are you more concerned with retirement?
• What is the time frame you're working with?
• What level of risk do you feel comfortable with?