The first step to understanding optimal asset allocation is to define its meaning and purpose. Asset allocation involves making investments in a number of different asset categories, such as bonds, stocks, and cash in order to diversify. It is up to each person to determine what their goals are, what their time horizon is, and what their personal risk tolerance is. There is no simple formula that can find the right combination for each person; it is a personal decision and everyone is different.

While asset allocation does not guarantee a return, it allows for investors to take part in the upside of their investments while managing the downside risk. All investments involve some degree of risk, including stocks, bonds, and mutual funds; even holding cash is risky when taking inflation into consideration. That being said, the most important benefit of asset allocation is reducing that risk in order to earn more stable returns by diversifying the portfolio. For example, investing in equities is highly-risky, and bonds provide stability. When one investment drops in value, the other may increase, offsetting the loss.

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The main goal of allocating assets is to minimize risk given an expected level of return. There are three things to consider when determining an asset allocation scheme: your time horizon, risk tolerance, and individual financial circumstance. Those with a longer time horizon may feel more comfortable with the high risk / high return characteristic of stocks, while those closer to retirement may want the dependability of the coupon payment while conserving capital. A portfolio may be more conservative or aggressive, depending on an investor’s personal preferences. Here are a few common strategies:

Conservative Portfolio: The goal is to protect the principal value. A conservative portfolio is for those investors with a short time horizon, and a low level of risk tolerance. Ideal for people in retirement or close to retiring.

• 70%-75% Fixed Income Securities
• 15%-20% Equities
• 5%-15% Cash and Equivalents

Moderately Conservative Portfolio: To protect the principal value while adding a bit more risk. For those investors with a short time horizon and a low level of risk tolerance.

• 55%-60% Fixed Income Securities
• 35%-40% Equities
• 5%-10% Cash and Equivalents

Moderately Aggressive Portfolio: Also known as “Balanced Portfolios,” these are equally split between equities and fixed income. Great for investors with a medium risk tolerance and a time horizon longer than five years.
• 35%-40% Fixed Income Securities
• 50%-55% Equities
• 5%-10% Cash and Equivalents

Aggressive Portfolio: Mainly consist of equities to achieve long-term growth of capital. Meant for those with a high-risk tolerance and long time horizon.

• 20%-25% Fixed Income Securities
• 65%-70% Equities
• 5%-10% Cash and Equivalents

Very Aggressive Portfolio: The main goal is aggressive capital growth over a long time horizon. This asset allocation would be for those with a high-risk tolerance and a long time horizon such as young adults.

• 0%-10% Fixed Income Securities
• 80%-100% Equities
• 0%-10% Cash and Equivalents

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Stocks, bonds, and cash are the most common types of assets. However, there are alternative asset classes including real estate and commodities depending on risk tolerance and an investor’s time horizon.

Stocks
Historically, stocks have had the greatest risk but also the greatest returns among the asset classes. In the short run, stocks can be very volatile, and during recessions take the biggest hit, as seen during the Great Recession when the Dow dropped 54% hitting 6,547 in March 2008. However, when held over the long term, with the benefits of diversification, stocks have outperformed every other asset class. Within stocks there are subclasses such as large-cap stocks, small-cap, international and emerging markets.

Bonds
Bonds are generally less risky than stocks, and less volatile, but their returns are also smaller. Typically, as an investor gets older, his or her portfolio might be geared towards having a heavier focus on bonds rather than stocks to reduce the risk of the portfolio. Within bonds there are also junk bonds, or high-yield bonds, that give higher returns, but are also riskier.

Cash
This includes holding cash or cash equivalents such as savings deposits, Treasury bills, and money market funds. This offers the lowest returns of any of the asset classes, but also has the lowest risk with only inflation to take into consideration.

Real Estate
The benefits of real estate include building equity and price appreciation, along with being an inflation hedge; rents received from tenants tend to rise with inflation. Further, if it’s a principal residence, any capital gains are tax-free. As an alternative to owning the hard asset, investors may also be attracted to investing in real estate investment trusts (REITs), which are exchange traded investment vehicles that give exposure to real estate with the ease and convenience of buying and selling on a stock exchange.

Commodities
Commodities along with real estate are “real assets” unlike stocks and bonds that are “financial assets.” Commodities therefore act differently than stocks or bonds and are a lot more volatile. They can be a good asset class for diversification and act as an inflation hedge, but investors should be prepared for wild swings dependent on supply and demand of the given commodity.

While choosing an asset allocation is crucial, ensuring it continues to match your investment objectives is also important. The value of the assets can change, affecting the weighting of each asset class over time, and your investment objectives and time horizon will also change, so investors should conduct periodic reviews. If by reviewing the portfolio it is determined that assets have to be rearranged, assets should be sold that no longer meet the objective or that have grown to a certain percentage of the portfolio and are thus distorting the risk/reward objective.

In the investing world, asset allocation is fundamentally important. It helps guide investors to maximize profits while minimizing risk. Whether your risk tolerance is conservative or aggressive, allocating your assets accordingly is critical, so be sure to select your portfolio wisely. Once it has been selected, remember to conduct periodic reviews of the portfolio to make sure you are on track. Only then can you be sure that the intended allocation will meet your long-term investment goals.