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INVESTING
SEPTEMBER 27, 2021

What is asset allocation, and how does it work?

Answered by
Anil Suri
Managing Director, Head of Asset Allocation and Portfolio Construction Analytics for Bank of America Chief Investment Office
Asset allocation is an important strategy that can help you to balance risk and reward within your investment portfolio by helping you determine how much to hold in different asset classes.Footnote 1 For most investors, these classes are typically stocks, bonds and cash. For each of these asset classes, there are different expected returns and risks. When they're combined in a way that provides your portfolio with both the possibility of growth and potential protection against loss, then you benefit from what is known as diversification.
Although asset allocation does not ensure a profit or protect against loss in declining markets, careful asset allocation is an important aspect of long-term investing. It can help you weather market highs and lows as you pursue your financial goals.
Once you determine the right asset allocation strategy for you and fund your investments, it's important to periodically review and, if necessary, adjust them. That's known as 'rebalancing' your portfolio. The mix of stocks, bonds and cash you've invested in can be thrown out of balance by the inevitable ups and downs of the markets. But periodic rebalancing can help keep your portfolio in line with your target asset allocation and the goals you want to achieve.

Here's a hypothetical example of how rebalancing your investment portfolio could work:

  1. You decide that you're willing to accept a moderate level of risk, so you set your target allocation at 54% stocks and 44% bonds (and 2% cash).Footnote 1
  2. The values of your investments change over time. After six months, your portfolio is now weighted toward stock (60% stocks vs. 39% bonds and 1% cash).
  3. To maintain your target, you rebalance by selling roughly 6% of your equity holdings and reinvest that money in more bonds and cash.
"Careful asset allocation can help you weather market highs and lows as you pursue your financial goals."
— Anil Suri, Managing Director, Head of Asset Allocation and Portfolio Construction Analytics for Bank of America Chief Investment Office

How can I determine the proper asset allocation for my goals?

As a general rule, assets with higher levels of risk are also likely to have potential for higher anticipated returns, so dividing your portfolio among asset classes gives you the potential to balance both.
Examples of asset allocation based on your comfort with risk
Conservative hypothetical investment portfolio
58% Fixed Income
16% Cash
26% Equities
Moderate hypothetical investment portfolio
39% Fixed Income
2% Cash
59% Equities
Aggressive hypothetical investment portfolio
10% Fixed Income
2% Cash
88% Equities
Stocks are generally the riskiest asset, potentially offering the highest returns along with the greatest volatility. Bonds — especially government bonds — are often considered less risky, offering smaller returns in exchange for more stability. Cash is thought to be the most stable allocation, but with the least likelihood of appreciation. The percentage of each of these assets that make up your total portfolio should be based on your personal goals, time frame, liquidity needs and risk tolerance.
In general, if you're investing for a long-term goal, you may consider taking on more risk with your investments, as you have longer to ride out the inevitable ups and downs of the market. For example, someone saving for retirement 30 years down the road might want a portfolio heavily weighted toward stocks because they believe it may provide greater long-term growth. As that person nears retirement and has less time to recoup losses if stock prices drop, they may decide to invest a greater percentage of their portfolio in bonds and cash.
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Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Footnote 
Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets.
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Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.

Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

This material is not intended as a recommendation, offer or solicitation for the purchase or sale of any security or investment strategy. Merrill offers a broad range of brokerage, investment advisory (including financial planning) and other services. Additional information is available in our Client Relationship Summary (PDF).

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