Simply put, asset allocation is the distribution or allocation of your money among different investments such as stocks, bonds and cash.
What is asset allocation?
Asset allocation is an investing strategy that seeks to balance risk and reward by dividing a portfolio's investments to meet the investor's personal risk tolerance and goals.
The asset allocation that works best for you at any given point in your life depends on how long you are investing and your tolerance for risk.
Major asset classes
Stocks have historically earned the highest returns over the long term. You may want to include stocks or stock funds in your 403(b) plan account for their long-term growth potential. However, this asset class has also shown more short-term volatility in price than the others. Because of this, in most cases, you should plan to hold equities for the long term in order to ride out the ups and downs. Typically, a major part of the total return earned by equities comes from appreciation, or an increase in price. So, in order to get money out of an equity investment, you may need to sell it.
Fixed-income investments (bonds)
Bonds have historically earned lower returns and have experienced less volatility than equities over the long term. The lower volatility makes them suitable for short-term, as well as long-term, holding periods. Also, much of the return normally comes in the form of interest payments. So, you can receive an ongoing stream of income without having to sell investments.
Cash equivalents such as Treasury bills and money market funds, have experienced the lowest returns but also the lowest volatility of these three classes, over the long term. This asset class’s objective is liquidity – the ability to convert the investment into cash quickly and easily.
Each asset class responds in its own way to economic and market conditions. When you divide your money among the asset classes, one portion of your portfolio may be doing well as another faces a downturn. Understanding how they all work together can better prepare you for your retirement.