When talking about investing or portfolio construction, one of the core philosophies you should learn about is asset allocation.
What is asset allocation? It is an investment strategy that aims to balance the risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. The three main asset classes – equities (stocks), fixed-income (bonds), and cash – have different levels of risk and return, so each will behave differently over time.
In other words, it means that you don’t put all of your eggs in one basket.
The baskets inside your portfolio represent all the various investment markets where you can invest your money. There are so many asset classes available for investment today. Technology has greatly improved the distribution channel of potential investments for the everyday-investor. Beyond the three major asset classes listed above, here is a sampling of others:
- Large-cap US stocks
- Mid-cap US stocks
- Small-cap US stocks
- International stocks
- Emerging market stocks
- US bonds
- International bonds
- High-quality bonds
- High-yield bonds
- Managed futures
As you can see, there are a lot of baskets in which to put your eggs.
Once you’ve determined which baskets your eggs should be in (20% US stocks, 10% emerging markets…etc.) then the research to find out which are the best eggs begins.
If you determine that your appropriate asset allocation includes seven of those above baskets, based on your time horizon, goals and risk tolerance, then you will research all of the available eggs for those specific baskets. Ideally, you will get each basket filled with one, two or possibly three good eggs.
Because of the natural diversification of using multiple baskets (asset classes) and the various eggs (individual investments) inside each basket, your portfolio is less likely to have massive swings up or down, regardless of how one of those baskets perform. If one or two eggs turn out to be rotten, it doesn’t blow up your whole portfolio. On the flip side, if one or two eggs turn out to be amazing, high-flying performers, it doesn’t mean the entire portfolio will also.
Determine which baskets make sense for you based on your unique, personal financial situation and pick some good eggs to own. That is a high-quality recipe for long-term portfolio success.