Intro to asset allocation

Asset allocation made simple

Diversification is an essential investing principle that’s sometimes hard to grasp. The logic behind it: Most investments don’t move in the same direction at the same time. If you hold different types of investments (hopefully complementary ones), your winners and losers may balance each other out, resulting in less volatility in your portfolio.

To illustrate this idea, let’s take a look at a fun example.

If your portfolio were a lemonade stand

Imagine for a moment that you’re a 10-year-old who wants to start his or her own business. You decide to use the money you’ve saved from your allowance to set up a lemonade stand. On nice, sunny days, your friends and neighbors may be looking to stay cool, and you just might be able to sell a lot of lemonade—hopefully collecting mountains of quarters along the way.

But what if it was cold outside? What if it rained? Suddenly, selling lemonade wouldn’t seem like such a great idea. In fact, your lemonade stand would likely only be profitable if the sun was shining.

But what if, in addition to lemonade, you served something else—like hot chocolate? On bright, sunny days, you’d probably sell a lot of lemonade and only a little hot chocolate; on cold, rainy days, a lot more hot chocolate than lemonade. By expanding your offerings, you’d have a better chance to make money day in and day out, regardless of the weather.

The trade-off? By selling both products, you’d probably make less money on an average day than if you were able to just sell lemonade on sunny days. But you’d also lose less money when it’s cold. The risk to your business could be lower—and the money you’d make more consistent.

You could even take things a step further and add something to your menu that’s likely to be in demand all the time—cookies, for example. Who doesn’t like cookies? With three items on your menu, you’d have something for everyone: lemonade and cookies on sunny days, and hot chocolate and cookies on cold ones.

Naturally, you might ask: If people like cookies on both hot and cold days, why not just have a cookie stand and get out of the beverage business altogether? The problem: Cookies are a lot harder to make. You might need to get your parents to help you buy the ingredients. Plus, baking takes a lot more time and effort, which could increase your expenses.

Bottom line: You won’t make as much profit on cookies as you would on lemonade or hot chocolate. So having just a cookie stand probably wouldn’t be such a great idea. Adding cookies to your menu, though, could be a great way to balance out your business and earn profits more consistently.

Portfolios need balance too

In many ways, these are the roles that different types of investments play in a portfolio:

As with most things, moderation is key. While diversification may not always protect investors against losses, a balanced portfolio with these three types of investments may be more insulated from risk and less impacted by market volatility.

Asset allocation: Putting all the pieces together

When building a portfolio, the percentage you invest in each category—stocks, bonds, and cash—is commonly referred to as asset allocation. Different combinations of these categories have risk profiles that range from conservative (building in a lot of protection for rainy days) to aggressive (designed to try to take full advantage of the sunshine). Some popular examples of asset allocations include:

How to determine an asset allocation that reflects your goals can depend on a number of factors, including your investing timeframe, risk tolerance, and financial goals and situation. It’s important to weigh these considerations carefully—just like you would when choosing menu items for your lemonade stand—before putting your portfolio in motion.