“Asset Allocation” is how you have divided up your investments across different assets. You can have all your assets in one place, or you can use diversification to spread them around to reduce risk.
Whenever you pick stocks, open a bank account, get paid, buy something, or do anything with any resources, you are doing some form of “Asset Allocation”. Early on, the choice is simply “Spend” or “Save”, how you are using your money. But like most things with investment, it is never that simple.
For example, once you have chosen to “spend” or “save” a dollar, you have another choice to make:
- If I spend it, do I buy a video game or go out to the movies?
- If I save, do I put it in a savings account or hold it as cash?
For us, we care mostly about savings. So if you save $1000, you can save it as cash, put it in a savings account, or invest it.
- If you put it in a savings account, there are different kinds of savings accounts that may give you a higher interest rate, but limit how much you can withdraw.
- If you invest it, you can divide your investment between stocks, bonds, mutual funds, or ETFs
- If you invest in any stock, bond, mutual fund, or ETF, you will need to decide which specific ones to invest in
Of course, at every level you also have a choice of splitting your money and doing one thing with part, and something else with another. With your $1000, you can spend $300, hold $100 as cash, put $200 in a savings account, use $150 to buy Johnson and Johnson (JNJ) stocks, and invest the last $250 in mutual funds. That is a lot of choices to make, even with one small block of assets!
Choosing How To Allocate Your Assets
Every time you allocate your assets, you are making many choices at once
When you spend your assets, your main decision is Opportunity Cost. If you spend your money on one thing, you cannot spend it on another, so you need to make sure you are buying whatever it is that will give you the most benefit. You are also choosing not to save or invest, which means the benefit you get from buying something today should outweigh the benefit of having that extra investment return in the future.
When you invest, your asset allocation will be based on 4 main criteria:
- Risk: Sometimes taking bigger risks can give bigger rewards, but you still have the chance of losing big too. How much risk you can tolerate will dictate a lot of your asset allocation.
- Liquidity: How much do you want the freedom to move your money? Assets that you can quickly convert back to cash are said to be very “liquid”, while assets that are very difficult to convert to cash (like houses) are “illiquid”. How much you value being able to move your asset allocation over time will also dictate what kinds of things you invest in
- How much you have: You can only buy a house if you have the ability to pay for it, and that goes with most other investments as well. If you do not have the assets necessary for a minimum investment, some options may be not open to you. This is becoming less and less of an issue with stocks, bonds, mutual funds, and ETFs, however.
- Opportunity Cost: This is the same as with Spending; whatever you invest in one asset is money you cannot use to buy something or invest in something else.
When you balance these four criteria, you will start coming up with your asset allocation. Just because you value one more than the others does not mean all your assets will go to one place either; a person who values liquidity the most probably will not keep all their assets as cash, both because it is risky (cash can be easily lost or stolen), but also because there is only so much cash you need at one time, so you can hold lots of cash but still keep some invested.
Asset allocation is the basis for risk management, building a portfolio, and diversification