Investing isn't just about buying or selling the right stocks. It's about allocating your assets in the most efficient manner to produce maximum returns with minimum risk. The definition of asset allocation is how your portfolio is made up, proportionally, of different asset classes. The most common asset classes are stocks, bonds and cash. A poor job of asset allocation often will not overcome even the best investment selection.
An extreme example of this would be investors who were stung by the dot.com bubble bursting in 2000 and have kept 100 percent of their assets in cash ever since. While they may have earned 3 or 4 percent interest annually from their bank or credit union, it pales in comparison to the returns of stocks and bonds during that same period.
The opportunity cost of not being invested in those other assets is significant. Ten thousand dollars invested in cash at 3 percent over seven years would be worth $12,298.74. The same amount in bonds would total $15,036.30, and in stocks it would produce $19,487.17 (based on historical returns).
It makes sense to think about two things before establishing your portfolio: your time horizon (i.e., when you are going to need the funds) and your risk tolerance (i.e., how willing you are to lose your original investment in search of greater returns). The answers to these questions are critical to optimizing your asset allocation.
In terms of time horizons, there are generally three periods investors should consider when making an investment: short-term (less than one year), medium-term (one to five years) and long-term (five years or more). If you are planning to buy a house in the next year or two, it wouldn't make sense to invest in stocks or mutual funds. Conversely, if you are 30 and investing for your retirement, it wouldn't make sense to allocate a majority of your capital in bonds or bond funds.
By setting the time horizon before you invest, you're enabling your assets to perform the way they were intended: stocks for the long term, bonds for the medium term and cash for the short term. However, it's important to note that this is different for each individual and will vary based on your risk tolerance.
In its simplest form, risk tolerance is the amount you're prepared to lose on any given investment without a loss of sleep. Every investor is different. Generally, it's assumed retirees are the least tolerant of risk because they live on a fixed income and are outside the workforce. Having said that, there are many older people who want nothing to do with bonds, preferring stocks and the capital gains and dividends associated with them. It all comes down to what you're comfortable with.
It's important to remember that your risk tolerance is always changing. If the value of your stocks has risen significantly, your tolerance for losses is probably higher as it would take a major drop to produce negative returns. However, if such a correction were to occur, your tolerance for losses would suddenly disappear.
Asset allocation helps ensure that when one of your assets is underperforming, others in your portfolio can pick up the slack. It's not how each asset class performs, but rather how they all do as a single unit. In the end, you'll judge your investment success by whether or not you have more money in your portfolio at the end of a period of time than you had at the beginning of it.