Asset allocation means dividing your money among different asset classes such as stocks, bonds and cash equivalents (money market or other investments that can quickly and easily be converted to cash). Each asset class tends to react differently to economic and market conditions, so gains in one asset class may help offset losses in another. That can help reduce volatility (ups and downs) and manage risk.
Stocks tend to offer the biggest reward or greatest potential for growth over the long term, but also the greatest volatility from year to year.
Bonds generally have less growth potential than stocks over the long term, and the changes in year-to-year value tend to be less dramatic compared to stocks.
Cash equivalents generally have the lowest risk of these three classes, but historically have offered the lowest return over the long term.*
Asset allocation models often divide the asset classes as a percentage of your total portfolio. For example:
- An aggressive portfolio emphasizes stocks and may invest a small percentage in bonds and/or cash equivalents.
- A moderate portfolio is invested in a mix of stocks and bonds, with a small percentage in cash equivalents.
- A conservative portfolio focuses on low-risk, income-producing investments and cash equivalents, and may invest a small percentage in higher-risk stocks and bonds.
To choose an asset allocation that is appropriate for you, you should consider the following:
Your risk tolerance: If you can handle dramatic ups and downs in the market, an aggressive asset allocation may work for you. If you cringe at the possibility of negative returns, then you may find peace of mind with a moderate or conservative asset allocation.
Your time horizon: How many years do you have until you need the money? If your time horizon is long, you have many years to ride out volatility in the stock market. If your time horizon is short, then a moderate or conservative approach may be a better fit.
Your return needs: What is your end goal, and how much money do you need to save? For instance, if you’re saving for something big (such as retirement), you may need an aggressive approach to get there. Keep in mind that a conservative portfolio comes with a different kind of risk: that of failing to outpace inflation, which can undermine your ability to reach your long-term goals. Your asset allocation, or the mix of asset classes you use, plays a large role in determining the returns your money earns. A landmark study from the Financial Analysts Journal found that more than 90 percent of a portfolio's performance is determined by its asset allocation.
A Financial Advisor from Navy Federal Financial Group can help you create a strategy for your investments that strikes the balance between risk and reward that is right for you.
*Past performance is no guarantee of future results.