Asset allocation refers to how you diversify your investments to balance risk and reward according to your goals, risk tolerance and time horizon. You can spread your capital among asset classes like equities, bonds, cash and equivalents, and real estate according to your preferred strategy.

Asset allocation, explained

Your asset allocation is simply how you divide your portfolio among assets like stocks, bonds and cash. Each class comes with different risks and return potential, with stocks typically considered the riskiest and cash the safest. You can also invest in advanced assets like real estate, commodities and currencies, though they carry different risks.

Principles of asset allocation

Before building your ideal asset allocation, it’s important to define your:

• Financial goals and time horizon
• Expected total return
• Risk and return tradeoff 
• Optimal asset mix (for instance, 60% stocks and 40% bonds)
• Rebalancing and re-optimizing schedule
• Preferred degree of diversification

4 common asset allocations

There’s no single, simple formula for determining your perfect asset allocation. But the following common methods can help you build your framework.

Strategic

This method involves constructing an “efficient” portfolio based on an optimal asset mix. Essentially, you want to take the least possible risk to achieve your expected return.

Strategic allocations often use a diversified buy-and-hold approach to smooth over market downturns. You’ll also want to rebalance your portfolio periodically to maintain your optimal mix.

Tactical

Tactical asset allocations start with a baseline asset mix based on your goals and risk tolerance. Then, you adjust your portfolio to take advantage of:

• Economic conditions
• Market trends
• Potentially undervalued securities

With a tactical allocation, the goal is to generate higher returns by timing the market – carefully.

Constant-Weighting (Automatic)

With a constant-weighting, or automatic, asset allocation, you establish a baseline allocation. (For instance, 60% stocks and 40% bonds.) Then, you continually rebalance your portfolio to adhere to your preferred mix. You may find it helpful to invest with a robo-advisor that uses automatic rebalancing to help manage your portfolio.

Dynamic

Dynamic asset allocation is an active strategy wherein you constantly adjust your asset weighting as the market and economy move. Essentially, you cut your losses on your losers and double down on your winners.

What this means for you

How you allocate assets is one factor that determines your risk-return tradeoff. By investing in assets that respond differently to various market events, you can protect your wealth against economic downturns while increasing your growth potential.

One important note about asset allocations is that they shouldn’t stay stagnant. Generally, if you can stomach higher risk for a chance at higher rewards, you can allocate more funds into higher-risk assets. But as you approach your goals, you may want to switch to a more conservative allocation.

Determining the right asset allocation isn’t easy, especially if you’re new to investing. Fortunately, modern robo-advisors can make the process easier by pairing years of investment knowledge and client preferences. With a short survey, services like Q.ai can help you find the ideal allocation.