Investing Basics: What Is Asset Allocation?

Investment advisors often talk to their clients about “asset allocation” without much explanation. Too bad, because it’s worth your while as a retirement investor to understand what asset allocation is — and what it is not.

Business owners understand allocation well. They have a limited amount of incoming cash to spend on growing their business, so you have to pay attention to where it goes. A restaurant owner must pay his employees, suppliers, taxes and the like. Then, if there’s any profit, make a choice: Take a profit or put it back into the business.

Assuming our restaurant owner already draws a salary, the best choice is to reinvest. But in what? Expanding? More efficient equipment? A new hire? It’s a tough problem.

The long-term retirement investor faces the same fundamental question, but what is asset allocation for an investor? It’s putting money to work in the best possible place.

Some advisors may interpret this to mean market timing, that is, trying to get in and out of an investment at specific moments. Or buying certain asset classes based on the business cycle, the interest rate or some other factor in the economy.

The more accurate definition of asset allocation, however, is not investment vs. cash (cash is by definition not investing) but what collection of investments you own. Remember, a huge part of the gains we find in stocks happen over a small number of market days. Sit in cash and you miss those gains entirely.

So how do you limit your risk of down periods? By rebalancing. A powerful portfolio will own a selection of investment types, called asset classes, and rotate among them periodically.

Rather than attempt to move in and out of those asset classes, the smart portfolio sets a specific goal of owning, say, 60% U.S. stocks. If the U.S. stock market rises in value, that slice of the total pie becomes larger.

So if stocks rise to become 70% of the portfolio in value, you rebalance, selling off the extra gains and using the resulting cash to buy more of the rest of your portfolio.

Reducing risk

That’s what finance researchers mean when they say that asset allocation is responsible for 90% of observed returns. It’s not what you own, it’s the fact that you own investments (rather than cash) and take gains when they appear (by rebalancing) along the way.

Over time, you can reduce your risk by adjusting the asset allocation to become more conservative. At or near retirement, a risk-adjusted portfolio will be far less volatile than in previous years, helping you to hold on to your compounding gains.

There’s nothing tricky about this approach. Pension funds and endowments have used it for years, with great results. The important thing for retirement investors to understand how the rules of asset allocation apply to their long-term picture, and how adopting a sound strategy leads to a comfortable retirement.