8. Building an Investment Portfolio
b. Asset allocation
We have all heard the cliché “don’t put all your eggs in one basket.” It’s better to have many baskets. This is the idea behind asset allocation. It is based on the notion that different kinds of asset classes or categories behave differently in various economic scenarios. If one category does poorly in a given period, another is likely to make up some or all of the difference.
The typical “asset classes ” are stocks, bonds, real estate and commodities. Asset classes may be further broken down into large capitalization (large-cap) stocks (big, established companies), mid-cap stocks (medium-sized companies), small-cap stocks, and international stocks. To make this work, you decide how much of your investments to put in each category based on your risk tolerance and other factors.
For example, Erin, who’s 28 years old, might decide to invest 80 percent of her portfolio in stocks and 20 percent in bonds. However, her sister Rita, who is less comfortable with changes in market prices and thinks she may need some of the money in less than five years, might decide a 50/50 split between stocks and bonds would be better for her.
In any case, it is rarely a good financial strategy to put all of your investment money in one investment or even one type of investment, which brings us to diversification.