Asset allocation is ultimately about matching your investments to your own needs, goals and risk profile. Having a diversified portfolio of assets, versus simply holding your favourite company, can be the key to long-term investing success.
What it means:
Asset allocation is the proportion of your portfolio that you choose to devote to different kinds of investments (stocks, bonds, real estate, currencies, etc.). There are many different categories of investments — what we call asset classes — that investors can choose from when building a portfolio. They all behave in different ways. Equities (stocks) tend to climb higher over the long term in the form of capital gains and dividends, but their returns can be inconsistent year to year. Bonds produce steady annual income, and they return an investor’s capital when they mature. Other assets, such as gold or real estate, tend to rise and fall based on factors unrelated to stock markets. How much money you devote to each of these asset classes as a percentage of your entire portfolio is what we call asset allocation. In the past, ordinary investors often adopted a 60/40 allocation — 60% equities and 40% fixed income — to generate decent returns without taking on more risk than they could stomach. (The stocks would provide growth, the bonds would lower the volatility). Those saving for retirement might shift the balance more toward fixed income as they get older to help reduce the risk of losing capital but it means having less opportunity for growth. This is also where diversification comes in: Most people want to allocate their funds to different asset classes so that if one runs into trouble, something else keeps the portfolio stable. For instance, within equities, you might put some money in Canada, the U.S., Europe and emerging markets; within fixed income you might hold government and corporate bonds; you might also put a small percentage in gold and so on. Asset allocation can help enhance your returns and/or limit your risk.