Asset allocation is the idea that, by combining different classes of assets, you can greatly reduce the amount that your portfolio fluctuates up and down. You get increased stability and safety, probably at the expense of some gains.
For instance, if you invest only in Google stock, you'll have the chance of doing very well if Google does well, and the chance of doing very poorly if Google does poorly. If you invest in a more diversified portfolio, you'll have a much higher chance of keeping your money, with a lower chance of making a huge killing. (Remember, the most common way to make a small fortune in the stock market is to start with a big one.)
One of the basic tenets of investing is that you get rewarded for risk. If a particular asset or class of assets has a high return, you can feel assured that it has a high risk. Assets with a lower risk always have a lower return. Anytime you see anyone claiming high return with a low risk, you know you're seeing a fraud in action. (Bernie Madoff claimed this about his investments.)
Asset allocation allows you to mix high return (with high risk) investments with lower risk (and lower return) investments. This way you still get some benefit of high-risk investments, with much less chance of losing a major chunk of your investment.
Asset allocation (in other words, how and where to invest your money) is a huge topic, and I'll be writing about it at great length in the future as I get closer to Financial Competence.
There's two axes on which you'll be balancing your assets:
- Among types of assets -- stocks, bonds, and subclasses of both
- Among account types -- primarily tax-free retirement accounts and taxable accounts. You'll want some type of assets (which are subject to capital gains taxes) in a tax-free account, and others in taxable accounts.
Of course, since the Schofield family is still paying off debts, we're not yet doing any kind of investment -- we've got 2 to 3 years to become competent at investing before we actually have to do it. Which is good, because there's a huge body of knowledge about this topic that we're going to dive into together.
I can't end this article, however, without giving you, my Dear Reader, a suggestion for your own asset allocation. I'm taking this from The Investor's Manifesto by William Bernstein, from the "Young Yvonne" example. It's appropriate for anyone just starting out in investment:
- 25% Vanguard Total Stock Market Index Fund
- 25% Vanguard Total International Index Fund
- 50% Vanguard Short-Term Bond Index Fund
That mix of funds gives a great mix of lower volatility, lower risk, and higher returns. We'll be doing something similar to this once we get our debt emergency handled.