It’s important to understand the different asset classes and the role they may be able to play in your financial strategies. Many financial experts believe that asset allocation may be the single most important factor influencing long-term investment returns, regardless of short-term market fluctuations.1 You could potentially lower your investment risk and increase your chances of meeting your investment goals by maintaining an asset allocation that includes several different types of assets.
What Is Asset Allocation?
Asset allocation refers to the mix of different types of investments, such as stocks, bonds, and cash. Because each type of asset has unique risk and return characteristics, the asset allocation an investor chooses is typically determined by that investor’s financial goals, time frame, and personal tolerance for investment risk.
Here’s a closer look at the risk and reward characteristics of the major asset classes.
- Stocks: Over the short term, stock investments typically carry a relatively high level of market risk, or the risk that an investment’s value will decrease. However, stocks have historically earned higher average annual returns than other asset classes over longer time periods. Although past performance is no guarantee of future results, stocks may have the potential to generate long-term returns that outpace inflation at the highest rate through the years.
- Bonds: In general, bond investments may be less likely to experience severe short-term price swings than stocks, and therefore may offer lower market risk. On the other hand, bonds’ overall inflation risk may be higher than that of stocks, because bonds’ long-term return potential may be lower. Inflation risk is the risk that an investment’s rate of return will not exceed the rate of inflation, effectively reducing the purchasing power of that investment over time. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- Cash investments: Among the most stable of all asset classes in terms of returns, money market instruments generally carry very low market risk. At the same time, they don’t typically have the potential to outpace inflation by as wide a margin as stocks or bonds.
Your precise asset allocation needs may change throughout life, but your need for an appropriate asset allocation never goes away.
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1Asset allocation does not assure a profit or protect against a loss in a declining market.
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