What is Asset Allocation

Many investors wonder how to properly invest their portfolio to give them the best chance of achieving their financial goals. Most people have heard the saying “Don’t put all your eggs in one basket.” Well, what does this mean exactly for investing?

Zachary R. Mersberger, CFA®, CRPC, AIF®

Apr. 26th, 2017

Blue containers
Blue containers
What is Asset Allocation

I’m sure that all investors have heard the common phrase, “Don’t put all your eggs in one basket.” What does this really mean and how can you apply this to your investment plan for retirement or other major goals? Essentially, this saying is emphasizing the importance of asset allocation and diversification in your investments.

What is Asset Allocation?
Asset allocation is an investment strategy that has the goal of balancing risk and creating diversification by dividing your investment assets appropriately amongst major investment categories such as stocks, bonds, and cash. Asset allocation is one of the biggest drivers of long-term returns for investors, with many studies finding that the majority of a portfolio’s long-term results can be explained by its asset allocation (see Figure 1) We find, however, that many investors do not understand asset allocation and do not implement it properly.

Investors Goals
Proper asset allocation starts with analyzing an investor’s goals, risk tolerance, time horizon, liquidity needs, and many other factors. This conversation should result in having a very good idea of how much risk an investor is comfortable with and should be taking.

Risk Tolerance
Once the investor’s risk tolerance is known, we can begin to assign percentages of the portfolio that should be invested in risk assets and conservative assets to match the investor’s risk tolerance. Risk assets would typically be stocks, while conservative assets would typically be bonds or cash.

Once we have assigned percentages of the portfolio to stocks, bonds, and cash we can now move to the next step of proper asset allocation; ensuring the investor’s portfolio is properly diversified amongst the various investment choices or assets classes within the broad categories of stocks, bonds, and cash. There are many subcategories within stocks, bonds, and cash. Again, to have the proper asset allocation, an investor should have the right balance of exposure to these various subcategories. For example, within the category of stocks, there are the major asset classes of domestic (US) stocks, international developed world stocks, and emerging market stocks. You can drill down further into large-cap, mid-cap, and small-cap stocks in each one of these categories.

Then there are also stocks categorized as growth, value, or core stocks. As you can see, there are almost endless categorizations of stocks, and the same thing exists in the bond world. This is where diversification comes into play. By diversifying a portfolio broadly amongst many or all of these various asset classes, most studies find that over long-term periods of time investors will experience more consistent (and possibly higher) returns with less risk. Why does this happen? It is because these various asset classes do not move in lock-step with each other. So when stocks experience negative returns, bonds may experience positive returns and vice versa. Likewise, there may be periods where domestic stocks have negative returns and international stocks have positive returns and vice versa. By broadly diversifying their portfolio based on their risk tolerance and other major investor characteristics, investors can give themselves the best chance of achieving the investment results that will help them achieve their financial goals.

A big part of our investment process at Mersberger Financial Group is creating financial plans for clients to establish appropriate risk tolerances and also establish what financial goals our clients have. Once we know these two things we are able to recommend appropriate asset allocation plans and make sure that our clients stay diversified. Our goal is to help organize our clients’ financial lives, and helping them implement proper asset allocation is a big part of this process.

Please contact our office if you have any questions regarding this topic.

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