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JULY 1, 2019

What is asset allocation, and how does it work?

Answered by
Nick Giorgi
Investment Strategist, Chief Investment Office, Merrill and Bank of America Private Bank
Asset allocation is an important strategy that enables 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 you 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 value of your investments change over time. After six months, your portfolio is now weighted towards stocks (60% stocks vs. 39% bonds and 1% cash).
  3. In order to maintain your target, you rebalance by selling roughly 10% 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."
— Nick Giorgi, Investment Strategist in the Chief Investment Office, Merrill and Bank of America Private Bank

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 come with higher anticipated returns, so dividing your portfolio among asset classes gives you the potential to balance both.
Pie charts of sample asset allocation arrangements for conservative, moderate and aggressive investment strategies.]
The allocations of the hypothetical investment are for illustration only and do not constitute investment advice. They are being shown to illustrate how a portfolio changes over time. You should consider the number of years until you retire, your goals and risk tolerance. The stock and bond fund allocations will vary for each portfolio depending on the number of years both before and after the planned retirement. Asset allocation cannot eliminate risk of fluctuating prices and uncertain returns.
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 investment, 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, timeframe, 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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Footnote 1 Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets.

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