It’s no secret that throughout history common stock has outperformed most financial instruments. If an investor plans to have an investment for a long period of time, then their portfolio should be comprised mostly of stocks; however, investors who don’t have this kind of time should diversify their portfolios, i.e. include investments other than the stocks.
For this reason, the concept of “asset allocation” was developed. Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds, stocks, real estate, and cash. Each asset class has different levels of return and risk, so each will behave differently over time. At the same time that one asset is increasing in value, another may be decreasing or not increasing as much.
The underlying principle of asset allocation is that the older a person gets, the less risk he or she should face. After you retire you may have to depend on your savings as your only source of income. It follows that you should invest more conservatively since asset preservation is crucial.
Determining the proper mix of investments in your portfolio is extremely important. Deciding what percentage of your portfolio you should put into stocks, mutual funds, and low risk instruments like bonds and treasuries isn’t simple, particularly for those reaching retirement age. Imagine saving for 30 or more years only to see the stock market decline in the years before your retirement!