Why should you care about Asset Allocation?

Asset Allocation is like mixing colors to get the right shade for your taste. Like primary colors, there are only a handful of primary return drivers in the financial markets - bonds, equities and cash.

The asset allocation for your portfolio is the proportion of each of these primary assets that make up your portfolio.

Why is Asset Allocation Important?

Imagine you are in the market to buy a shiny new car. You have scouted all the dealerships around town until you finally found your dream car, but it will take three weeks for delivery to the local dealership for you to purchase. You will be receiving a stock award from your company next week. Selling the stock should provide enough money to make the down payment on the car.

When would you sell the stock, immediately upon receiving it or, on the day the car payment is due?

Many would choose to sell immediately upon receiving the stock because the stock price is so volatile that it may lose considerable value over the course of just a few days if there is some bad news about the company, and you may not have enough money to buy your car. If you sell the day you receive the stock and put it all in cash, you are pretty much assured the value of that cash will remain about the same on the day of the car payment.

What we just discussed is switching your allocation from stock to cash. If you are decades away from your retirement, you can tolerate higher fluctuations in your retirement portfolio, so you may allocate a higher portion of your assets to equities. It might even be desirable because you expect this allocation to earn a higher return. But, as you get closer to your retirement, you do not want the value of your retirement portfolio to fluctuate widely. So you would gradually change your asset allocation from a high allocation to equity to a portfolio with a lower proportion of equity, in favor of less volatile assets such as bonds and cash.