Investors often find the concept of asset allocation confusing or intimidating — at least initially. But it's actually quite simple. Asset allocation is nothing more than determining in which types of assets your investment capital should be placed. This determination is based on variables like net worth, time frame, risk acceptance, and other assets the investor owns. Generally, properly allocating your investment dollars means assembling a portfolio primarily from the three major asset categories: cash, fixed income, and equities. Cash includes money in the bank, short-term investments such as U.S. Treasury bills and money market mutual funds, both of which are considered “cash equivalents,” meaning they can be very quickly converted to cash. Fixed-income investments include bonds, guaranteed investment certificates, and other interest-generating securities. Equities are stock market investments. Equities can be further subdivided into more specific categories, such as value and growth.

It is a tricky business to achieve the right mix of stock types (small, mid, and large caps, as well as internationals, just to name a few) and bonds (short, medium, and long-term, corporate and government) for maximum return. To complicate matters, you must take into account your volatility tolerance and the diversity of your investments. For that reason, considering whether to consult a qualified financial planner or advisor to help you during this critical planning stage should be at the top of your investment to-do list.

Time and Asset Allocation

Many financial advisors say, quite sensibly, that your asset allocation plan depends on where you are in life. If you're just starting out, a long-term strategy that emphasizes stocks is advised. This strategy tends to emphasize growth of assets by investing in more aggressive stocks. In order to moderate risk, it may also include a commitment to income investments, such as bonds. An example of a portfolio that employs a long-term strategy may include 70 percent equities, 25 percent bonds, and 5 percent short-term instruments or cash.

If you're nearing or are in retirement, advisors often advocate a short-term strategy that relies more heavily on bonds to place more emphasis on capital preservation. This strategy is designed to emphasize current income, capital preservation, and liquidity, while maintaining a smaller portion of the portfolio in stocks for growth potential. An example of a portfolio that employs a short-term strategy may include 50 percent bonds, 20 percent equities, and 30 percent short-term instruments or cash.

Two Ways to Allocate Assets

There are two primary ways of allocating assets. The first method is to use a stable policy over time. Based on your income needs and risk tolerance, you might pursue a balanced strategy. This might require putting 25 percent of your dollars in each class of assets, such as stocks, bonds, cash, and real estate. Each quarter or year, rebalance those dollars to maintain your original allocation of 25 percent in each class. This forces you to sell off some of the best-performing assets while buying more of the weakest performers. This allocation system eliminates the need to make decisions on the expected return for each class and instead allows for more stable returns over long periods of time.

The alternative is an active strategy. Use your tolerance for risk and your long-term goals as the basis for your allocations to each class. Thus, if you need a good mix of growth and income, you might allow your investment in stocks to range from 35 percent to 65 percent of your portfolio, based on the market. You would develop these ranges for each asset class.

Obviously, an active strategy requires a lot of homework and a good knowledge of the financial markets and what impacts them. You'll have to track your investments at least weekly and adjust your holdings based on your revised expectations — as well as on their actual performance. You'll also have to take into account greater market forces and trends, changes in the global political and economic scene, even seasonal differences in sector performance. If you consistently make the right calls (an outcome that becomes more frequent as you gain experience and insight), you can make substantially higher returns.

Organizing your asset allocation campaign is a fairly straightforward process once you get the hang of it. Keep in mind, though, that your asset allocation plan is subject to change over time; what's right for you today may not be five years from now. Your asset allocation strategy can be changed to accommodate your life changes.