Importance of Asset Allocation

What is an Asset Class? What is Asset Allocation? How should you determine your Target Asset Allocation?

If you read my blog often enough, and have started to think I qualify everything I write about as ‘most important’ – then you are mistaken (and partly it is my fault). I might be saying those things in a different context.

For example, when I say compounding is your biggest friend, I mean it, but keep in mind that compounding happens over a period of time. When I say Asset Allocation is the most important factor in determining long term returns, I do not mean to say asset allocation is more important than compounding.

Things apart from Asset Allocation are important too, specially how much you save and how soon you start to save, how much expenses do you have etc; but once you have started to save/ invest, Asset Allocation is what will be a primary driver of your long-term returns.

What is Asset Allocation?

Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes.

If you do not understand big jargon like Asset Allocation and Asset Class (and some others) we are talking about today, please do not be discouraged, read till the end. I am introducing these terms so that you can interpret and understand host of information that is available on the internet on this topic.

I could have explained the basics even without using any jargon but I want you to be able to read that Wall Street Journal article with confidence the next time you see it, so getting familiar with the jargon is essential.

What is an Asset Class?

An asset class is a group of ‘investments’ that share riskiness and return. Three main asset classes in stock market are stocks, bonds, and cash. Let us focus on stocks and bonds for now. Stocks are more risky but provide higher returns long term.

By risky, I mean the returns on stocks are more volatile – they might return 25% in a single year but might lose 25% of the value also in a given year. But over a long period of time, their annualized returns are most likely going to be higher than bonds.
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