Asset allocation describes how an investor distributes their investments among various classes of investment options (e.g., stocks and bonds). Most successful investors will tell you that asset allocation is the most important decision you make in determining how well your portfolio performs. As noted in my recent article Charlie Munger's 10 Rules for Investment Success, he pointed out "Allocate assets wisely: Proper allocation of capital is an investor's No. 1 job."
The conceptual foundation of asset allocation is the premise that the best-performing asset(s) will vary from year-to-year and is not easily predictable. By spreading your investments across various asset classes, some will be over-performing while under-performing - Don't put all your eggs in one basket. With fixed percentages on each of the asset classes you reallocate out of the better performing assets into the under-performing assets - Buy Low, Sell High.
Examples of asset allocation classes include, by asset type: Cash, Bonds, Stocks, Real Estate, Currencies, Natural Resources, Precious Metals, Collectibles, etc.
When looking at equities they can be sub-divided into additional asset classes grouped by:
- Size such as: Large-Cap, Mid-Cap and Small-Cap
- Style such as: Growth, Blend and Value
- Sector such as: Financial, Consumer, Industrial, Health-care, etc.
- Other such as: REITS, International, Emerging Markets, Life Settlements
There are a lot of tools available on the web to help you determine your asset allocation. Here are three, one very simple and the other two a little more comprehensive:
As described in my article "Process Overview and Asset Allocation", I currently allocate assets broadly by the type of investment (mutual funds, ETFs, dividend stocks) with some attention given to sectors within my dividend stocks. I am currently working on refining my process and will discuss this in future posts.
If you are interested in learning more about asset allocation, The U.S. Securities and Exchange Commission (SEC) has a good primer on asset allocation titled "Beginners' Guide to Asset Allocation, Diversification, and Rebalancing".