Asset allocation refers to the mix of investments inside your portfolio - how much of your portfolio is in stocks, bonds, cash and other asset classes. It also refers to your investments within each asset class. The objective is to find a mix of investments that can potentially increase your savings while keeping your risks at a level that's appropriate for you.
Sometimes the terms "asset allocation" and "diversification" are used interchangeably. However, not all asset allocations provide the same level of diversification. For example, a portfolio that is divided evenly between US stocks, Canadian stocks, Japanese stocks and European stocks won't offer you much protection if stock markets slump worldwide.
True diversification means investing in a mix of assets that perform differently in various economic environments. By diversifying, you "spread the risk" because one asset class may be performing well when another isn't.
This chart shows you how three asset classes have typically performed in different economic environments — and illustrates why it's important to diversify your investments. Historically, some asset classes move in opposite directions, some in the same direction and some have no pattern of correlation.
| Asset Class Performance Differs in Different Economic Environments |
| |
Inflationary
Growth |
Noninflationary
Growth |
Recessionary/
Deflationary |
| Equities |
 |
 |
 |
| Fixed Income (Government Bonds) |
 |
 |
 |
| Commodities |
 |
 |
 |
Source: Invesco. Time period represented September 1976 through December 2010. For illustrative purposes only. Commodities are represented by the S&P Goldman Sachs Commodity Index, which is an unmanaged composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. Bonds are represented by the Barclays Capital U.S. Treasury Index, which is an unmanaged index of public obligations of the US Treasury with a remaining maturity of one year or more. Stocks are represented by the S&P 500® Index, which is an unmanaged index considered representative of the U.S. stock market. Stocks may decline in response to investor sentiment and general economic and market conditions. Fixed Income products, such as government bonds, are subject to the effects of changing interest rates. Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds. An investment cannot be made directly in an index. Past performance is not a guarantee of future results. |
The mix of assets you should choose depend largely on:
- Your time horizon — the length of time you have to invest before you retire.
- Your risk tolerance — your financial ability and emotional willingness to take risk in pursuit of reward.
Once you determine an asset allocation that's right for you, monitor it regularly to make sure you're staying on target and determine when rebalancing may be necessary.
You may also have the option of investing in so-called lifestyle, life stage or target date funds, which are professionally managed portfolios of individual securities or mutual funds. Asset allocation and diversification are predetermined by fund managers. These funds are designed to meet the needs of:
- A particular type of investor.
- Investors in a particular age group.
- Investors at a certain life stage.
As you get closer to your financial goal, your asset allocation will need to be adjusted. Generally, the less time you have before you reach your goals, the more conservative your asset allocation should be. In addition, life changes, such as having children and changing careers, should trigger a re-evaluation of your asset allocation.
A target date fund identifies a specific time at which investors are expected to begin making withdrawals, e.g., Now, 2020, 2030. The principal value of the fund is not guaranteed at any time, including at the target date. Asset allocation/diversification does not guarantee a profit or eliminate the risk of loss.
