What is asset allocation? How to build the best portfolio for your investment goals

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Putting your money on the market is always a risky move. There is no guarantee that your investments will thrive, nor a proven way to determine where best to put your money so that it will grow and you will make money over time. However, there is a way to build a portfolio that aligns with your goals, your timeline to achieve them, and your ability to tolerate any market swings. Enter the asset allocation.

What is Asset Allocation?

Asset allocation is essentially how you invest in different asset classes (like stocks, bonds, cash, commodities, real estate, and so on) to reduce the level of risk you take on. Some asset classes are considered riskier than others, and by not putting all your eggs in one basket, you give yourself the best possible chance of coming out on top, even if the market takes a turn for the worse.

“Asset allocation is important because it is an important part of how a portfolio can perform over the investment horizon. Maintaining a diversified asset allocation is especially important in times of volatility,” said Veronica Willis, investment strategy analyst at [hotlink]Wells Fargo[/hotlink] Investment Institute. “Diversification across groups of assets that don’t necessarily move up and down together can help reduce downside risk in a portfolio and reduce the volatility of returns.”

How asset allocation works

When deciding on the right composition for your portfolio, it’s important to remember that your portfolio should be unique and tailored to your preferences and financial goals. Every investor has their own timeline, unique goals and risk tolerance, and your portfolio should reflect this. Some factors you may need to consider when choosing assets to invest in and how much to invest:

Your Risk Tolerance: Risk tolerance refers to the amount of loss an investor is willing to tolerate when making an investment decision. “Investors with a high risk tolerance can typically manage a higher allocation in stocks, while investors with a low risk tolerance should focus on an allocation mix with less high volatility assets,” Willis said. “Your time horizon can also play a role in this. Investors with a longer investment horizon have time to recover from market downturns and therefore may have a higher risk tolerance than those with a short investment horizon.

Your investment goals and time horizon: Determining what you’re investing in will help you choose assets that align with your goals. If you’re investing to earn extra income, you’ll want to consider an asset like stocks or dividend bonds. However, if you’re looking for more long-term growth or to supplement a nest egg for your future self, you can bet more on stocks that will grow over time. “Investors with a focus on both growth and income may want an allocation that includes a balance between profitable assets and assets that are expected to drive growth,” Willis says.

Liquidity: An asset’s liquidity tells investors how easily it can be converted into cash without affecting the market price. Some assets are easier to exchange for cash, such as bonds or certificates of deposit. Other assets, such as a real estate investment, are more difficult to convert into cash easily.

What do you do once you have built your portfolio?

Once you’ve determined your asset mix, loosen the reins a bit and rebalance your portfolio periodically. Rebalancing happens when you reset your portfolio to get back to a level of risk you feel comfortable with. Over time, some investments will grow faster than others, which can change your preferred positions and compromise your asset allocation. By rebalancing, you ensure that you are not over- or under-invested in a particular asset class.

“Regularly rebalancing your portfolio can help enforce discipline of buying low and selling high,” says Willis. “Rebalancing at least once a year is a good strategy to ensure your portfolio is on track and meeting your goals.”

This story originally appeared on Fortune.com

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