Why understanding asset allocation is key

  • Determining the mix of investment types is one of your most important tasks as an investor.
  • How you allocate assets should be based upon your unique financial goals, time horizon and risk tolerance.
  • Regardless of whether you need a portfolio that is more concentrated in stocks or bonds, you should consider diversifying within each asset class, too.
Calculator and paper sheets with data
Mario Gutiérrez | Moment | Getty Images

Most investors are extremely diligent in determining what investments should be a part of their portfolios. Certainly, you want to make sure that any specific security or fund is serving a purpose and is chosen because it has the potential to meet your needs and goals.

However, what investors often overlook or neglect is their specific asset allocation. The truth is that the combination of investments in your portfolio can actually be more important to achieving your goals than the specific investments selected.

The role asset allocation plays

Determining the mix of investment types is one of your most important tasks as an investor. Every investment has different strengths that allow it to play a specific role in your overall strategy. For instance, some investments may provide regular income while others may serve as a temporary place to hold for cash. Some even have multiple purposes and can fill more than one role.

Because you probably have multiple goals, you need a combination of investments to help you achieve short- and long-term objectives. That's the purpose of an intentional asset allocation strategy. The key is to manage risk while seeking to achieve a targeted rate of return.

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To illustrate that concept, let's look at a hypothetical situation. Let's say your goal is to achieve a 7.5 percent return on your investments. Let's assume stocks can average a 10 percent return per year and bonds can return 5 percent annually. One possible way to achieve your 7.5 percent goal is to select a 50-50 mix of stocks and bonds.

That being said, this is not a foolproof strategy, and there's no way to predict if it will work out exactly that way. There is no guarantee that investments will perform the same way as they did in the past. However, being intentional about your asset allocation gives you a place to start.

Determine an asset-allocation strategy

You might be asking yourself how to know what asset allocation is right for you. Ultimately, the answer is based upon your unique financial goals, time horizon and risk tolerance. Knowing what those are will help you determine the appropriate mix of stocks, bonds and cash for your individual portfolio.

If you have a shorter time horizon and are leery of taking on risk, you may be best served to consider a conservative asset allocation model that is designed to produce income. That type of portfolio is typically heavily weighted in bonds and cash.

On the other end of the spectrum is a more aggressive model. If your goals are geared toward longer-term growth and you are comfortable taking on more risk, you may consider a portfolio that is more heavily weighted toward stocks and stock funds.

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Diversify investments

Regardless of whether you need a portfolio that is more concentrated in stocks or bonds, you should consider diversifying within each asset class, as well. For instance, if you are investing in stocks, you might want to hold some large-cap stocks, mid-cap stocks and small-cap stocks. You might also base your investment decisions on geography, holding both domestic and international stocks.

Similarly, when it comes to your fixed-income allocation, you might want to hold bonds of various maturities. Or you might favor tax-free bonds depending on your tax situation.

Beyond stocks, bonds and cash, other asset classes to consider for diversification may include real estate and alternative investments, such as hedge funds and private equity funds.

Stay on top of asset-allocation strategy

Determining your portfolio's ideal asset allocation is not a set-it-and-forget-it process. It's important to regularly make sure your asset allocation reflects your current financial situation, time horizon and risk tolerance. The choices you made even one year ago might no longer be furthering your goals.

The next time you're taking an analytical look at the holdings in your portfolio, cast an equally critical eye on your allocation to make sure everything is working toward your current and future needs.

(Editor's Note: This column originally appeared on Investopedia.com.)

— By Rich Ramassini, director of strategy and sales performance, PNC Investments