During the investment process, the issue of asset allocation comes up. Asset allocation is the method of dividing your investments into the major asset classes of cash, bonds, and stocks. The investment returns you seek and the amount of risk you are willing to take will influence how your money will be allocated.

Personal Things To Consider

When determining your asset allocation, there are various factors to consider. They include:

•  Your age

•  Your income

•  Your assets (includes your home, cash and investment portfolio)

•  Your debts (includes mortgage and line of credit)

•  Years to retirement

All these personal considerations will help determine how aggressive or conservative your investment portfolio should be.

How It Works

To demonstrate how asset allocation works, each asset class is described.

Cash: Of the three asset groups, cash is considered the most secure. It is also the one with the lowest returns. Cash is short term debt with maturities of less than one year issued by corporations and governments. Cash includes term deposits and U.S. treasury bills. At maturity, the principal and interest will be repaid in full. Investment funds are usually placed in cash to wait for a better price to purchase stocks or bonds.

Bonds: Bonds are debt products with maturities longer than one year. Corporations and governments issue bonds with maturities lasting as long as thirty years. Interest payments are made every six months. The principal is redeemed at maturity. Bonds are divided in two groups. Short term bonds have terms of between one to five years. Long term bonds include terms of between six to thirty years. Bonds are purchased for income and safety.

Stocks: Stocks are purchased for growth. A stock or a share represents a unit of ownership in a corporation. If the company does well financially, the value of the shares will increase. Of the three asset classes, stocks have the most growth potential but are also considered the most risky.

Asset Allocation Assumptions

Asset allocation is heavily influenced by the age of the investor. The assumption is the younger the investor, the greater the emphasis of the portfolio on growth. Stocks tend to provide superior growth over the long term and the young investor can ride out the fluctuations. If the investor is close to retiring, the emphasis will be more on preservation of capital and income. Bonds will make up a large part of the investment portfolio.

To determine the percentage of the portfolio funds to be invested in stocks, you take 100 less the investor's age. The short term financial requirements of the investor will determine the cash component. The remainder will be placed in bonds.

Example

Let's use an investor who is 40 years old and won't plan to retire until the age of 65. The investment portfolio will be used to build his nest egg for retirement.

Cash: 10% will be put aside to take advantage of lower prices for stocks and bonds.

Stocks: 60% = 100 - the investor's age.

Bonds: 30% is the remainder of the portfolio.

This is a simplified example of asset allocation. Other factors such as risk tolerance and special needs must be factored in.

Conclusion

Building a first-rate investment portfolio requires asking the right questions and being realistic about your financial situation. To meet your investment objectives, a slow and steady performer is the best option. This means having a well balanced portfolio of cash, bonds and stocks.