Understanding Asset Allocation

Asset allocation is the primary tool in the battle to build a diversified portfolio. This is the task of figuring out how much of your portfolio will be invested in different asset classes, such as stocks, bonds, or cash.

Asset allocation has been recognized as a very important part of the process of building a portfolio. In fact, one study has found that your decision as to how you will divide up your portfolio into several classes is more important than the process of choosing the actual stocks, bonds, and funds that you will own.

In developing your asset allocation strategy, you should remember that, generally, the younger you are, the more risk you can afford to take. As you get older and closer to retirement, you'll probably be less interested in the growth of your portfolio and more interested in capital preservation -- protecting the value of your portfolio from any declines. Preserving your portfolio as you reach your desired retirement age becomes more important since a large decline in the value of your holdings can affect your retirement lifestyle, or even make it impossible to retire according to your plans.

One rule of thumb that many experts use is to subtract your age from 100 to determine the percentage of investments to invest in stocks. If you're 45, then you might put together a portfolio that's 55 percent stocks and 45 percent bonds and cash.

Most full-service brokerage firms maintain a suggested asset allocation for their customers. The firm's chief investment strategist determines the optimal percentage of a typical portfolio that should be invested in particular asset classes at any time, and updates the asset allocation strategy on a regular basis. There are also advisors who recommend a portfolio that's always invested 100 percent in stocks, on the theory that this asset class delivers the best return.