Asset allocation is the process of dividing one’s resources among many different choices. In terms of investments, “assets” refers to investible cash, and “choices” refers to investments that are available to purchase. Asset allocation refers to the percentage of an investment portfolio that is contained in each individual investment. For example, a portfolio’s asset allocation may be 80% stocks, 15% bonds, and 5% gold. No matter the actual allocation, the primary goal of asset allocation is diversification. Diversification means spreading investment risks over many different asset classes, so that “not all your eggs are in one basket.”Asset classes are sectors of investment that have differing risk characteristics. Anything that can be invested in can be categorized into some asset class. Examples of asset classes include:
1. Stocks – shares of ownership in a publicly-traded company
2. Bonds – a legal claim on the assets of a company, municipality, or other government entity
3. Precious Metals – physical metals such as gold, silver, platinum, and palladium
4. Commodities – physical goods produced and traded such as corn, wheat, coal, and oil
5. Hedge Funds – investment funds that undertake a unique trading strategy in other asset classes
6. Real Estate – ownership of physical property such as land, apartment building, or rental house.
Instead of deciding whether it is better to invest in stocks or bonds, over long-time horizons it is nearly always optimal to invest in stocks and bonds. Why? Because of risk diversification. When the stock market is experiencing turbulence, bonds tend to hold steady and oftentimes experience positive price appreciation. Between investing in 100% stocks or 100% bonds, there are more “efficient” opportunities for an investor to pick up more return for very little additional risk or to substantially reduce risk without greatly compromising return.
This example is only taking into account combining two funds, the S&P 500 index fund and the Barclay’s Aggregate bond market index fund. By opening the investment opportunities to include additional bond sub-sectors (municipals, corporates, etc.) and equity sub-sectors (financials, utilities, energy, etc.) the frontier of opportunities improves further. The Efficient Frontier of opportunities makes another substantial improvement when Alternative Investments (such as options funds, managed futures, real estate funds, etc.) are added to the mix.
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