Market & Investing

Asset Allocation 101: What It Is and Why It's So Important

Asset allocation is the cornerstone of every investment strategy. Learn about why it matters.

You’ve probably heard the saying, "Don’t put all your eggs in one basket." This idea of diversification is especially relevant when it comes to investing. Simply put, utilizing different types of investments can help protect your assets when some are underperforming, and capture returns when others are performing well.

 

The process of dividing your portfolio among different categories of investments, or asset classes, is called asset allocation. Asset allocation helps you balance your risk tolerance, time horizon and financial goals—and it’s one of the most significant factors in your investment outcomes. Let’s go over the basics of this important concept.

Asset Classes Explained

There are four major asset classes—stocks, bonds, cash (or cash equivalents) and alternatives—each with a different risk and return profile. In the world of investing, generally the higher the potential risk, the higher the potential return.

 

Stocks: Stocks represent shares of ownership in a company. They have high return potential, so they’re often used to achieve growth in an investment portfolio, but they also carry high risk.

 

Bonds: Bonds represent loans to a corporation, financial institution, government or municipality. Investors can potentially make money from the interest payments on bonds issued. Historically, bonds have been less risky than stocks, but they tend to generate lower returns.

 

Cash and cash equivalents: Cash and cash equivalents—such as money in an interest-bearing savings or money market account—tend to have the lowest risk among the major asset classes, but their returns are negligible and may not keep up with inflation over the long term.

 

Alternatives: Alternatives are assets—such as real estate, art and private investments—that fall outside of the traditional markets. These generally carry the highest risk but may offer qualified investors the opportunity to diversify their portfolios into categories that aren’t necessarily correlated to market fluctuations.

Finding the Right Asset Allocation for You

So how do you decide what percentage of your portfolio to devote to each asset class? Your asset allocation will typically depend on these three factors:

 

Time horizon: This is the amount of time you have to meet your financial goals. For example, you might be aiming to buy a house in the next five years, or to retire in 25. Generally speaking, the longer your time horizon, the more risk you may be willing to take on, both since you won’t need to access the money for a while and because your portfolio has time to recover from market downturns.

 

Risk tolerance: This is the amount of market risk, or volatility, you’re comfortable taking on. Most investors can be described as conservative, moderate or aggressive. Conventional wisdom ties risk tolerance to age, assuming younger investors are more aggressive because their portfolios have time to bounce back from bear markets, while older investors are conservative because they need to preserve their assets. But the reality is that risk tolerance is shaped by your attitudes and goals, not age alone—and it can change throughout your life.

 

Financial goals: The nature of your financial objectives determines how much money you need and when you need it. Whether you’re investing to finance a wedding, start a business, pay for your children’s tuition, or retire on your own terms, you may wish to calibrate your portfolio accordingly. 

The Bottom Line

Asset allocation is one of the greatest determining factors in your investment outcomes. To choose the allocation that’s right for you, consider your risk tolerance as well as your financial goals and time horizon for meeting them. If you need some guidance, consider working with a financial professional who can help you develop a strategy tailored to you.

This article has been prepared for informational purposes only. The information and data in the article has been obtained from sources outside of Morgan Stanley. Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of the information or data from sources outside of Morgan Stanley. It does not provide individually tailored investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this article may not be appropriate for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Morgan Stanley Smith Barney LLC ("Morgan Stanley"), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for legal matters.

The investments listed may not be appropriate for all investors. Morgan Stanley Smith Barney LLC recommends that investors independently evaluate particular investments, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment will depend upon an investor's individual circumstances and objectives.

Equity securities may fluctuate in value in response to news on companies, industries, market conditions and the general economic environment. Companies paying dividends can reduce or stop payouts at any time.  Past performance is no guarantee of future results.    Investing in stock securities involves volatility risk, market risk, business risk, and industry risk. The prices of stocks fluctuate. Volatility risk is the chance that the value of a stock will fall. Market risk is the chance that the prices of all stocks will fall due to conditions in the economic environment. Business risk is the chance that a specific company’s stock will fall because of issues affecting it such as the way the company is managed. Industry risk is the chance that a set of factors particular to an industry group will adversely affect stock prices within the industry.

Alternative investment securities discussed herein are not covered by the protections provided by the Securities Investor Protection Corporation, unless such securities are registered under the Securities Act of 1933, as amended, and are held in a Morgan Stanley Wealth Management Individual Retirement Account.

Asset allocation, diversification and rebalancing do not assure a profit or protect against loss. There may be a potential tax implication with a rebalancing strategy.  Please consult your tax advisor before implementing such a strategy.

Morgan Stanley at Work services are provided by Morgan Stanley Smith Barney LLC, member SIPC, and its affiliates, all wholly owned subsidiaries of Morgan Stanley.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

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