Asset allocation: CNBC Explains

Asset allocation refers to the most fundamental decision in investing: where to put your money.

Is there an optimal mix of asset classes to employ when putting together a portfolio? Is the answer to this question the same for everyone?

CNBC explains.

Asset allocation refers to the selection of securities and asset classes in which one can invest. It's the same idea that you might hear referred to as "portfolio composition" or, more simply, "investing mix."

The most common types of securities for investors are stocks of publicly traded companies (shares of Apple and General Electric, for example) and bonds (such as a 10-year U.S. Treasury bill issued by the government). Stocks and bonds are themselves divided into asset classes, like large-cap, mid-cap and small-cap stocks, which are references to the size of the company; U.S. stocks vs. international developed world stocks; developed world stocks vs. emerging markets stocks; government bonds vs. corporate bonds; and investment-grade corporate bonds vs. high-yield bonds.

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And asset allocation is more than just stocks and bonds. Simply having cash under the mattress or something similar (e.g., money in a bank checking account or a money market fund) is an asset class by itself. And other possessions, like a house, a car or even an expensive piece of jewelery can be considered part of asset allocation, because they have value and in theory can be sold.

There are additional types of assets beyond stocks and bonds, making the choices even more difficult. For institutional investors, "hard assets," also referred to as "real assets," can include farmland, timber, other real estate holdings and commodities, like metals. Investment firms also sell retail investors on these means of diversifying their assets, such as buying gold- and silver-focused securities; and more complicated funds that put investor money in real estate projects (so-called REITs) or oil and gas pipelines (MLPs), for example.

Regardless of how someone allocates their assets, virtually everyone should practice some type of diversification to lower the risk of losing a lot of money at once—the less diversified a portfolio is, the greater the volatility, because the decline in one asset exerts too great a toll on the portfolio's performance.

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The Securities and Exchange Commission compares different asset allocations to a sidewalk vendor selling both umbrellas and sunglasses.

"Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never—and that's the point," the SEC explains on its investor-education website.

"Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items—in other words, by diversifying the product line—the vendor can reduce the risk of losing money on any given day."

So what is the right mix of investments? That's what people on Wall Street, wealth advisors and commentators in the financial media think and talk about virtually every day.

One basic idea to think about is liquid and illiquid assets. Liquid assets are things that can be turned into cash very quickly. The most liquid asset is, of course, actual cash. Money in a checking or savings account or even stock investments can be turned into cash fast, usually within a day or two. More illiquid investments, like owning a home or a car, take much more time to turn into cash because it's more difficult to sell. If you might need money quickly, it's important that your assets aren't all tied up in illiquid holdings.

One classic approach to creating a market-based portfolio is to have 60 percent of an investor's wealth in stocks and 40 percent in bonds. But that mix doesn't work for everyone. Risk is ideally increased or decreased depending on individual circumstances, such as age, future expenses or family wealth. Typically, the greater the percent of stocks in the portfolio, the higher the risk: More bonds mean less.

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Someone young who is saving for retirement may want their asset allocation to be heavily weighted to stocks. Someone who is retired will likely hold more bonds to minimize the risk of losing money as compared to stock holdings, and also to benefit from the income generated by bonds, which is important to many older citizens living on pension plan distributions and Social Security payments. Cash may seem like it has no risk, but there's the opportunity cost of what it could have been invested in and the risk that inflation will decrease its value over long periods of time—just think how $1 buys a lot less today than it did 10 years ago.

Asset allocation can look very different for everyday investors versus high-net-worth individuals and institutions that manage large sums of money. Those who are deemed "accredited" investors by the U.S. government usually have at least $1 million to invest and can put their money in so-called "alternative" assets, not just stocks, bonds and mutual funds. Those "private" funds include hedge funds, private equity funds, venture capital funds and more. The structures of those funds and the things they invest in can be more dangerous and difficult to understand, which is why they are limited to people that theoretically have more financial experience or, at the very least, a greater tolerance to assume investment risk because they are wealthier.