Asset Allocation

To invest wisely, you don't just need good investments—you need the right combination of them. With the right mix, you can potentially increase your returns, while reducing (although not eliminating) risk. We'll explain how asset allocation works—and how you can get started using it.

What is asset allocation?
Simply put, asset allocation means spreading your investments across three major asset classes: stocks, bonds and cash or cash equivalents (such as money market funds).

Asset allocation doesn't mean you have to invest in individual securities. If you prefer to invest in mutual funds, for example, you could cover all three asset classes by investing in stock mutual funds, bond mutual funds and money market funds.

Taken to a finer level, asset allocation can also apply to spreading your investments across different subcategories of the three main asset classes—such as government, municipal and corporate bonds, or industry groupings of stocks.

The amount you invest in each class depends on personal factors—such as your financial goals, your comfort with risk, your income, liquidity of your assets and how much money you have to invest.

Why use it?
Why spread your money around this way? Historically, different asset classes have reacted differently to changes in the economy. The classes tend to move up and down independently. So if you allocate your investments to different asset classes, you can diversify your portfolio, potentially reducing your overall risk and potentially improve your returns.

Historically, over the long term stocks have offered the best opportunity for growth, but also come with the highest level of risk. Bonds can provide steady, fixed income—and have historically been less risky than stocks—but also tend to have lower potential for returns. Cash equivalents offer the least risk, but also the least opportunity to grow your money.

Step 1: Take a good, hard look in the mirror
Before you can wisely allocate your assets, you need to understand at least four things about yourself:

• Your tolerance for risk. Some investors are conservative—they don't like taking big risks when they invest. Others are aggressive—they don't mind taking big risks as long as they have a chance for big returns. Others fall somewhere in between.
  
  
• Your financial goals. If you're like most people, you invest for reason—or for several reasons. Maybe you plan to use money from your investments to buy a house, pay for a college education, retire in style or take a nice vacation. Write down each of your goals and how much money you estimate you'll need for each one.
  
  
• How much time you have. When do you plan to use the money from your investments? Depending on your goals, you may have several different timelines—for instance, you might plan to go on vacation in one year, buy a house in two years, send your child to college in 12 years, and retire in 22 years.
  
  
• How much you have to invest. Your amount of dispensable income will play a part in how you allocate your assets.

Step 2: Put your plan in place
Once you've defined the four items above, you can start calculating how much to allocate to each asset class. Generally, the younger you are (and the more time you have before you plan to spend the money from your investments), the greater the risk you may be able to handle. The closer you are to needing the money, the more you may want to protect your investments.

For instance, if you're young, aggressive and have plenty of time before you plan to use money from your investments, you might allocate 70 to 100 percent of your portfolio to stocks and stock mutual funds. If you're more conservative, you might allocate 50 percent to stock mutual funds, 40 percent to bond funds and the rest to cash equivalents.

Because figuring out the right asset allocation can be complex, you may want to sit down with your investment professional, who can help you clarify your goals and recommend an asset allocation to meet your needs.

Step 3: Stay in the game
Once you allocate your assets in a way that's right for you, keep in mind that asset allocation is not a one-time event—it's an ongoing process. Because your life, your goals and the world around you change over time, you'll want to revisit your plan on a regular basis.

For example, market fluctuations can throw off the most carefully planned asset mix. If your stock funds outperform your other investments, stocks may end up being a much larger percentage of your portfolio than you originally planned—which could expose you to more risk than you want.

For these reasons, having an ongoing relationship with an investment professional is a good idea for many investors. You may want to review your goals, investments and asset allocation with your investment professional once a year, for example, and make any needed adjustments.

Find an investment professional at a WaMu financial center near you for a free consultation.