The Pros And Cons Of Asset Allocation

With thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor.

So instead of stock picking, you should start by deciding what mix of stocks, bonds and mutual funds you want to hold - this is referred to as your asset allocation.

What Is Asset Allocation?
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time.

For instance, while one asset category increases in value, another may be decreasing or not increasing as much.

We can, however, outline five points that we feel are important when thinking about asset allocation:

1. Risk Vs. Return
The risk-return tradeoff is at the core of what asset allocation is all about. It's easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest "potential" (stocks and derivatives) isn't the answer.

The crashes of 1929, 1981, 1987 and the more recent declines of 2007-2009 are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. It's time to face the truth: every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return.

Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you can't keep invested through the short-term fluctuations of a bear market, you should cut your exposure to