Asset allocation means dividing an investment portfolio among different classes of investments, typically including stocks, bonds and cash.
It's important because the investment classes tend to behave differently under different market conditions. Stocks, for example, tend to rise when the economy rises and plunge when it falls. Bonds lag stocks in the boom years, but they don't fall as far when times are tough. Cash is the ultimate stabilizer when inflation is low, but high inflation turns it into a loser.
Building an Asset Allocation Plan
You, as a retirement investor, have no way of knowing what the future holds. But if a portion of your investments are set up to take advantage of the world's market conditions, no matter what they might be, you are giving yourself the best chance to benefit from the good times and protect yourself in the worst.
Look at it this way: Tire manufacturers don't know what the weather is going to be on any given day, any more than you do. But they do know that in most of the country, part of the year will be winter and part will be summer. So they allocate their production to make two basic types of tires -- fair weather and snow tires -- so they have the right inventory to sell under any conditions.
So how do you build an asset allocation that works for you? The first step is a bit of self-analysis.
Asset Allocation and Time to Retirement
Take a look at how much time you have.
It's relevant because younger investors can afford to take more risks -- and thus benefit more from good economic cycles -- because they have the time to recover from the losses they take when times are not so good. Older investors, with less time to recover, need to be more cautious, and that generally means that they rely more greatly on bonds and cash.
Asset Allocation and Risk Tolerance
Then ask yourself: How much risk can you stand?
If the thought of losses gives you hives, you might want to ease up on the stocks. Not too much, though -- studies have shown through the years that cash investments, like money market funds, don't keep up with inflation over time, and bond returns are far outpaced by stocks.
On the other hand, if you're fine with taking big losses on occasion because you know bigger gains are on the way, load up more on stocks. But again, don't overdo it -- every investor needs some bond and cash holdings to cushion the stock market's inevitable slides.
An online calculator from The Iowa Public Employees Retirement System and one from Money-zine.com can help you approximate an allocation that could work for you.
