LAST REVIEWED Jun 08 2020 8 MIN READ
Creating a strong investment portfolio is an effective strategy if you want to increase your finances. Asset allocation involves dividing up your investments among different asset categories to ensure you’re still receiving a fair amount of return without losing too much money from other assets. In this article, we explore what asset allocation is, why it’s important, and how you can split your assets into different categories.
What Is Asset Allocation?
Asset allocation is an investment strategy that balances and compares your company’s risks and rewards. To successfully complete an asset allocation, analyze and adjust the percentage of the main asset categories in your investment portfolio based on your goals, risk tolerance, and time frame of your investment. These main asset categories are cash, stocks, and bonds.
How well certain assets perform depends on the market they’re in and the economic conditions. Some assets are unpredictable and may not produce returns in the time frame or amount that investors may expect. By diversifying your assets, you can reduce the risk of losing financial stability by investing an appropriate amount in different assets.
Why It’s Important to Diversify Your Assets
Asset allocation strongly impacts your overall investment returns and the how large of a risk you’re taking when investing. Completing a proper asset allocation allows you to wisely spread your investments among different categories according to your current financial goals, investment schedule, and risk tolerance.
By holding investments in various asset categories, returns may fluctuate throughout these financial assets at different times, depending on market conditions. For example, if a stock investment falls, you may lose money from this category, but your investments in other assets may still increase, causing you to still earn money and take a smaller financial hit.
If the investment return for one of your categories decreases, there’s often a large possibility that an investment return in a different category increases, keeping you from losing much of your investments. If you divide your portfolio wisely, you can have a fairly significant amount of control over how much you gain from your investments.
Advantages of Diversifying Your Assets
When you diversify your assets within your investment portfolio, you receive significantly high returns, all while lowering your overall financial risk. For example, if your investment portfolio contains several stocks and bonds, rather than just a single bond or stock, your portfolio will look healthier and not as financially risky.
Disadvantages of Undiversified Assets
If you have many assets all in one category, your financial risk may increase because you’re investing all of your financial resources in one category rather than diversifying and spreading it among several assets. For example, if you’re investing in several stocks, but no cash or bonds and the stock market crashes, you may financially be at risk and without any safety nets.
Investing in asset categories like stable bonds may reduce your risk of losing principal funds, but your risk of not receiving high enough returns to meet your financial goals may increase. It may even make it more difficult to properly maintain your overall buying power in case inflation were to occur. This is why it’s especially beneficial to cover yourself financially by properly diversifying your assets.
What Are Asset Classes?
Asset classes are groups of economic resources that hold similar financial characteristics, like risk and return. Sort your assets into alternative or traditional classes. Cash, stocks, and bonds fall into the traditional assets class. Alternative assets can include:
Collectibles like art, stamps, and coins
Residential or commercial real estate
Market neutral strategies
Venture capital foreign currency
Advantages and Disadvantages of Cash Assets
The Federal Deposit Insurance Corporation insures all cash assets, which means they keep up to $250,000 per depositor secured in the bank and have kept every account’s money protected since 1933.
You can usually reserve cash for short-term spending items like daily living expenses or emergency funds. A large purpose of cash assets is to have it on hand in case an unexpected event occurs and you need your money quickly. Cash assets are also beneficial because they can allow you to meet any short-term goals like a down payment on a car or house.
The odds of losing money when you make a cash investment are usually high. Even though a cash investment is safer than investing in other asset categories, cash offers the lowest return out of all three traditional classes.
What Are the Different Kinds of Bonds?
Different types of bonds include:
Companies often issue corporate bonds to raise money for different business capital expenditures, like research projects or new factories. Local government uses municipal bonds to raise money for an abundance of city needs, like the construction of new hospitals, schools, or parks.
Advantages and Disadvantages of Stocks
Out of all the asset categories in your investment portfolio, stocks can offer you the greatest financial growth potential. Though they can earn you a significant amount of money, they also have the highest risk and return out of all three traditional asset categories.
The unpredictability of stocks can make them risk short-term investments. Large company stocks have historically lost money approximately one out of every three years. Though these losses have been large, investors have found that the risk of keeping their stocks in larger companies have a chance of providing them significant positive returns.
The Best Allocation
Finding the best way to allocate your portfolio’s assets depends on personal factors like financial goals, age, and risk tolerance. It can be most effective to choose the best assets based on your investment goals and time horizon. The asset investment decisions you make may change over time, too. You should review your asset allocation at the end of each year, and make any changes so they go into effect at the beginning of the new year.
Investing in financial opportunities like a 401(k) retirement plan are big financial decisions to make. We can help you through that process. Contact us today to get started on finding a retirement plan that meets your financial needs.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.