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INVESTING | The Concept of Asset Allocation

The Concept of Asset Allocation


If you have visited a big city, you've probably run into street vendors -- people who sell everything from hot dogs to umbrellas in carts on the streets and sidewalks. Many of these entrepreneurs sell completely unrelated products, such as coffee and ice cream.

At first glance, this approach seems a bit odd, but it turns out to be quite clever. When the weather is cold, it's easier to sell hot cups of coffee. When the weather is hot, it's easier to sell ice cream. By selling both, vendors reduce the risk of losing money on any given day.


Asset Allocation


Asset allocation applies this same concept to managing investment risk. Under this approach, investors divide their money among different asset classes, such as equity, income, alternatives, and cash. These asset classes have different risk profiles and potential returns.

The idea behind asset allocation is to offset any losses in one class with gains in another, and thus reduce the overall risk of the portfolio. It's important to remember that asset allocation is an approach to help manage investment risk. It does not guarantee against investment loss.


Determining the Most Appropriate Mix


The most appropriate asset allocation will depend on your unique situation. Among other considerations, it may be determined by two broad factors.

  1. Time. Investors with longer time frames may be comfortable with investments that offer higher potential returns but also carry higher risk. A longer time frame may allow individuals to ride out the market's ups and downs. An investor with a shorter time frame may need to consider market volatility when evaluating various investment choices.

  2. Risk tolerance. An investor with high risk tolerance may be more willing to accept greater market volatility in the pursuit of potential returns. An investor with a low risk tolerance may be willing to forgo some potential return in favor of investments that attempt to limit price swings.

Asset allocation is a critical building block when creating a portfolio. Having a strong knowledge of the concept may help as you consider which investments may be appropriate for your long-term strategy.


Importance of Allocation


A landmark study found that asset allocation accounted for 91.5% of portfolio returns. Only 8.5% of portfolio returns could be attributed to the selection of specific securities.


Source: Brinson, Singer, and Beebower, "Determinants of Portfolio Performance II: An Update," Financial Analysts Journal, May/June 1991.

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