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Asset Allocation Basics

In order to protect your assets from sustaining losses when a sector suffers a decline you should practice asset allocation. This means that you spread your resources among different categories of investments, which compensates the decline of one stock through the increase in another.

Often believed to be one of the most important factors that may influence your chances of success in stock investing, many experts advise asset allocation to be practiced with the greatest caution.

When applying asset allocation you should concentrate on combining stocks, bonds and cash in different proportions. The process of asset allocation is the selection of the percentage by which each investment category will be present in your portfolio.

Consider the following example to see how asset allocation works. John has decided to allocate his assets among stocks, bonds and cash. The following tables represent the exact proportion of each of them in his portfolio.

Stocks 70%

  Income Stocks Growth Stocks Small-Cap Stocks Foreign Stocks
Percentage 10% 45% 5% 10%

Bonds 20%

  Long-Term Bonds Mid-Term Bonds
Percentage 13% 7%

Cash 10%

  Short-Term Bond Fund
Percentage 10%

This asset allocation is not the one you should follow. This is just an example to see how it works.

When you consider the asset allocation that best works for you, you should consider the following factors:

  1. Your risk tolerance
  2. How much income you earn
  3. How much savings you have accumulated
  4. How many years you have until retirement

As mentioned above, a good asset allocation will greatly increase your chances of fighting the ups and downs of the market, because the down in one investment will be compensated by an up in another investment.

After considering the stated above factors, you should make sure that once per quarter (at least) you examine your portfolio in order to check whether it is properly balanced. If the market conditions are experiencing more turbulent times, do this more frequently.

You should also examine the percentage you have assigned to each investment category to see whether they properly fit your needs and conditions.

Generally, the younger the investor the more aggressive investing strategies s/he can undertake since s/he has enough time to beat the ups and downs of the market. The closer the investor gets to retirement, the more conservative his/her investing strategy should get because s/he has less time to fix the potential losses. Additionally, an early start in investing greatly increases you chances of achieving your investment goals.

Asset Diversification vs. Asset Allocation

Don't fall in the common confusion about asset allocation and diversification. There is a difference between the two. Asset allocation and diversification are similar in this that they both advice the avoidance of investing in just one category. However, asset allocation goes further by assigning percentage to each investment type that will be present in the investment portfolio.

Summary of Asset Allocation Basics

Asset allocation is the spreading of assets among different categories of investments, typically among stocks, bonds and cash. It provides protection against drastic market volatility and the corresponding fluctuations. When you allocate your assets you should have in mind different factors, the most important one being your risk tolerance.

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