You are here: InvestorDIY.com > Education > Asset Allocation / Risk & Diversification
The term Asset Allocation refers to how your financial resources are distributed throughout the various asset classes available (cash, bonds, stocks). Cash investments will be the most stable (least risky over the short term) but offer the lowest return, whereas stocks can fluctuate wildly over short time periods, yet offer increased returns for those willing to ride out the volatility. The practice of allocating your assets among the different investments available allows you to create a mix that behaves the way you want it to.
For example, if you want maximum returns and are willing to leave the money alone for 10 years or more, heavily weighting the stock component of your portfolio makes sense. If you need to save for a down payment on a house you'll be buying in a few months, cash investments would be the most appropriate. People who are conservative with their money (can't stand the thought of losing 30% of their contributions in a short time period) will typically allocate less to stocks than those who feel they can tolerate a financially wild ride toward retirement.
While I can't explain everything about asset allocation, I can give a few guidelines. First, the further you are from retirement, the safer it is to have a large proportion of your investment portfolio in stocks. Second, the greater your tolerance for risk, the more you can psychologically afford to allocate to stocks. One rule of thumb I like is to take the number 120, subtract your age, and the result is the percentage of your portfolio that should be in stocks (with the rest in bonds). While this is a gross oversimplification of how you should actually approach the subject, it's a good start. If you're early in your career, dedicating 100% of your retirement portfolio to stocks may not be unreasonable. Even when you retire, most financial planners suggest you still keep a healthy portion of your portfolio in stocks (maybe 40-60% depending on your situation) to make sure your assets will continue to keep up with inflation to support you throughout the rest of your life. I would say that most working people (ages 20-60 or so) should probably have between 60 and 80 percent of their retirement portfolio in stocks, with the rest in short or intermediate-term bonds, saving the cash investments for their emergency fund. As retirement approaches, it makes sense to shift some of the stock allocation to more stable bonds (max 60% stocks?), to prevent the wild swings that could wipe out a large chunk of your nest egg right when you need it.
For more on asset allocation, read anything by William Bernstein. His two books, though slightly technical, are the best things I've read on the subject. I prefer The Intelligent Asset Allocator a bit more, but The Four Pillars of Investing is really good too (and a little more broad in scope). There's also a lot of good information online if you like searching around that way.
The subject of risk in investing is an interesting one. There are all kinds of risk. The big one most people are afraid of is the risk of losing your money. For this type of risk, cash is safer than bonds, which are safer than stocks (these are general rules here, there are always exceptions). That risk refers primarily to the risk of default, but also the up and down swings in the principal invested. Cash investments, particularly those insured by the FDIC, aren't going to lose money. Ever (okay, they could, but it's really not at all likely). Stocks can go down anytime (and often do), frequently by a lot. Bonds are somewhere in between, depending on what kind you have. That's why cash pays the least, and stocks pay the most (over time). There is a direct correlation between risk and reward in this case. But there are other kinds of risk, including the risk that your investments won't keep up with inflation (reducing your purchasing power), or the risk that you won't have enough saved when you want to retire to enable you to do so. For these risks, cash investments are much "riskier" than stocks over the long term.
Diversification is also important here. If everything you own is invested in Microsoft's stock (MSFT), and they fail as a company, you have nothing left. Companies disappear fairly frequently, and their stock often becomes worthless almost overnight (rally cry: remember the Enron!). So obviously holding just one stock isn't a good idea. Holding only a few is also a bad idea, for much the same reasons. The more stocks (or bonds) you have, the lower the chance that they're all going to fail you. A diversified portfolio averages out the bumps in the ride, and you get something a little more stable and predictable. That's why I like mutual funds so much. Unless you have a spare hundred thousand dollars to create your own diversified stock portfolio, a mutual fund gives you a lot of diversification for little cost. Besides, stock picking doesn't really work according to the efficient markets theory. It also makes sense to diversify within asset classes. With stocks, for instance, you should probably hold big companies (known as large caps), small companies (small caps), and both growth and value stocks. You should hold some stocks from the United States, and some from other countries. Personally, I have about 60% of my stock holdings currently in domestic stocks, and the other 40% in international stocks, but this definitely overweights international holdings more than most financial planners recommend (15-25% international is more typical). True followers of the indexing philosophy (who often like to hold each security in proportion to its market representation) would have about 60% international stocks and 40% domestic stocks, since companies from the United States make up a little under half of the companies throughout the world, but I've never seen this allocation recommended, I guess because international stock markets rarely have the history of relative stability that our country enjoys, and therefore there's a perceived larger threat of volatility and risk there.