Investing Portfolio Management Asset Allocation for Beginners An Introduction to Diversifying Among Asset Classes By Joshua Kennon Joshua Kennon Twitter Website Joshua Kennon is an expert on investing, assets and markets, and retirement planning. He is the managing director and co-founder of Kennon-Green & Co., an asset management firm. learn about our editorial policies Updated on October 20, 2021 Reviewed by Samantha Silberstein Fact checked by Julian Binder In This Article View All In This Article Model Determined by Need What Are the Four Model Types? How Do Needs Change Over Time? The Rebalancing Controversy Strategy Photo: DNY59 / Getty Images In simple terms, asset allocation is the practice of dividing resources among different categories: stocks, bonds, mutual funds, investment partnerships, real estate, cash equivalents, gold, private equity, and more. The theory is that the investor can lessen risk; that's because each asset class has a different correlation to the others. For instance, when stocks rise, bonds often fall. At a time when the stock market begins to fall, real estate may begin to produce above-average returns. The amount of an investor’s total portfolio placed in each class is determined by an asset allocation model. These models are designed to reflect the personal goals and risk tolerance of the investor. Furthermore, individual asset classes can be sub-divided into sectors. For example, if the asset allocation model calls for 40% of the total portfolio to be invested in stocks, the portfolio manager may recommend different allocations within the field of stocks, such as recommending a certain percentage in large-cap, mid-cap, banking, or manufacturing. Key Takeaways Asset allocation may be determined by age. Younger investors can take more risk to grow wealth, while those who are older may make safer bets to preserve wealth.Most asset allocation models fall somewhere among four objectives: preservation of capital, income, balanced, or growth.If you are actively engaged in an asset-allocation strategy, you will often find your needs change as you move through the various stages of life. Model Determined by Need Decades of history have proven it is more profitable to be an owner of corporate America (e.g., stocks) rather than a lender to it (e.g., bonds). But there are times when equities are unattractive compared to other asset classes. For example, think about late 1999 when stock prices had risen so high that the earnings yields were almost non-existent. There are other times that equities do not fit with the goals or needs of the portfolio owner. Suppose you're a single older adult with $1 million to invest and no other source of income. You'd want to place a large portion of your wealth in fixed-income obligations that will generate a steady source of retirement income for the remainder of your life. Your need would not be to necessarily increase your net worth; instead, you'd want to preserve what you have and live on the proceeds. A young employee who is just out of college, on the other hand, would be most interested in building wealth. They can afford to ignore market fluctuations; that's because they don't depend upon their investments to meet day-to-day living expenses. A portfolio that is heavily based on stocks, under reasonable market conditions, is their best option. What Are the Four Model Types? Most asset-allocation models fall somewhere among four objectives: preservation of capital, income, balanced, or growth. Preservation of Capital Asset-allocation models designed for the preservation of capital are largely for those who expect to use their cash within the next 12 months. They often do not wish to risk losing even a small percentage of principal value for the possibility of capital gains. Those who plan on paying for college, buying a house, or starting a business could be those who would seek this type of model. Cash and cash equivalents, such as money markets, treasuries, and commercial paper, often compose upward of 80% of these portfolios. The biggest danger is that the return earned might not keep pace with inflation, which could erode purchasing power in real terms. Income Portfolios that are designed to generate income for their owners often consist of investment-grade, fixed-income obligations of large, profitable corporations; real estate (most often in the form of Real Estate Investment Trusts, or REITs); Treasury notes; and, to a lesser extent, shares of blue-chip companies with long histories of dividend payments. Income-oriented investors may be nearing retirement. Or they may be a single parent with small children; they might be receiving a lump-sum settlement from their partner's life insurance policy and can't risk losing the principal. While growth would be nice, the need for cash in hand for living expenses is most important. Balanced Halfway between the income and growth models is a compromise known as the "balanced portfolio." For most people, the balanced portfolio is the best option. That's that's not just for financial reasons; it can also be the best choice emotionally. Portfolios based on this model attempt to strike a balance between long-term growth and current income. The ideal result is a mix of assets that generate cash; at the same time, the goal is for these assets tp appreciate over time with smaller fluctuations in quoted principal value than the all-growth portfolio. Balanced portfolios tend to divide assets between medium-term investment-grade fixed-income obligations and shares of common stocks in leading corporations; many of these may pay cash dividends. REITs are often a component as well. For the most part, a balanced portfolio is always vested. Note Being "vested" means very little is held in cash or cash equivalents unless the portfolio manager is absolutely convinced that there are no attractive opportunities demonstrating an acceptable level of risk. Growth The growth asset-allocation model is designed for those who are interested in building long-term wealth. The assets are not required to generate current income; the owner is employed and living off their salary. Unlike with an income portfolio, the investor is likely to increase their position each year by adding funds. In bull markets, growth portfolios tend to outperform their counterparts significantly; in bear markets, they are the hardest hit. For the most part, up to 100% of a growth modeled portfolio can be invested in common stocks, but a substantial portion might not pay dividends. Portfolio managers often like to include an international equity component to expose the investor to economies other than the U.S. How Do Needs Change Over Time? If you are actively engaged in an asset-allocation strategy, you will often find that your needs change as you move through the various stages of life. For that reason, some financial professionals recommend switching over a portion of your assets to a different model a few years prior to making major life changes. If you are 10 years away from retirement, for instance, you might move 10% of your holdings into an income-oriented allocation model each year. By the time you retire, the entire portfolio will reflect your new objectives. The Rebalancing Controversy One of the most popular practices on Wall Street is “rebalancing” a portfolio. This often happens because one certain asset class or investment has advanced substantially and comes to represent a large portion of the investor’s wealth. To bring the portfolio back into balance with the original model, the portfolio manager will sell off a portion of the appreciated asset and then reinvest the proceeds. Famed mutual fund manager Peter Lynch calls this practice “cutting the flowers and watering the weeds.” What is the average investor to do? If the fundamentals have not changed, and the investment still seems attractive, it may be smart to keep it. On the other hand, there have been cases, such as WorldCom and Enron, where investors have lost everything. This is perhaps the best advice: Only hold an outperforming position if you are capable of evaluating the business operationally; are convinced that the fundamentals are still attractive; believe the company has a significant competitive advantage; and you are comfortable with the increased dependence upon the performance of a single investment. If you are unable or unwilling to commit to these criteria, you may be better served by rebalancing. Strategy Many people believe that diversifying your assets to follow an allocation model will reduce the need to use discretion in choosing individual stocks. That is a dangerous fallacy. If you are not capable of evaluating a business, you must make it absolutely clear to your portfolio manager that you are interested only in defensively selected investments, regardless of age or wealth level. The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Macrotrends. "NASDAQ Composite - 45 Year Historical Chart."