The Importance of Asset Allocation
Numerous studies have shown that asset allocation is the single biggest determinant of a portfolio's long-term returns and volatility. The decision of how much to allocate to stocks versus bonds will have a far greater impact on your results than the specific stocks or bonds you choose. The goal is to create a mix that aligns with your risk tolerance, time horizon, and financial goals.
Major Asset Classes
The primary asset classes used in portfolio construction are:
- Equities (Stocks): Offer the highest potential for long-term growth but also come with the most volatility.
- Fixed Income (Bonds): Generally less risky than stocks and provide a steady stream of income. They often perform well when stocks are performing poorly, providing a stabilizing effect.
- Cash and Cash Equivalents: Includes savings accounts, money market funds, and short-term Treasury bills. They are very safe but offer the lowest returns.
- Alternatives: A broad category that includes assets like real estate, commodities, and private equity.
Determining Your Asset Mix
Your personal asset allocation should be based on your specific circumstances. A young investor with a long time horizon can afford to take on more risk and would typically have a higher allocation to stocks. A retiree who is drawing income from their portfolio would have a higher allocation to bonds and cash to reduce volatility and preserve capital. A common rule of thumb is the "110 rule," which suggests subtracting your age from 110 to determine the percentage of your portfolio that should be in stocks.
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