DESPITE ITS (OFTEN) FORGETTABLE NAME, asset allocation is an essential concept to remember, because it directly ties the composition of your portfolio—that is, the amount of stocks, bonds and cash you hold—to your financial goals and aspirations. It also helps you factor in your investing time horizon, comfort with risk and liquidity needs, or funds for unexpected expenses.
A great way to illustrate how asset allocation works is the classic pie chart (see our graphic below). This shows the relationship between how much market risk you’re comfortable with and the percentage of stocks, bonds and cash you could consider holding. A general rule of thumb: The more risk-averse you are, the more you’ll want to be invested in “safer” assets, like high-quality bonds and cash. On the other hand, if you’re more comfortable with risk—and you have a longer time horizon to invest—you could consider holding a greater percentage of stocks. They’re more prone to short-term price swings but offer potential for greater long-term growth. Our easy-to-use Identifying Your Allocation Profile questionnaire can help you determine what type of investor you are.
Keep in mind, asset allocation is not a one-time “set-it-and-forget-it” process. “Changes in the markets can cause your allocation to drift over time,” points out Marci McGregor, senior investment strategist for Bank of America Global Wealth and Investment Management, in our video above. So you might consider rebalancing your portfolio on a regular basis to ensure that it reflects your current preferences for stocks, bonds and cash.