What is asset allocation?

You've probably heard the adage about the danger of putting all your eggs in one basket. The same is true for investing.

It's risky to invest everything in a single asset or even limit yourself to a narrow slice of the investable universe. If those holdings lose value, your portfolio goes along for the ride. But spreading out your money among numerous types of investments can reduce the chances of catastrophic losses. Asset allocation strategies can help you accomplish that.

Asset allocation is the practice of thoughtfully diversifying your holdings—or investing in a variety of investment options—to manage risk while pursuing growth.

The markets and the economy often affect your investments, but different types of investments respond in different ways. For instance, when the economy shows signs of softening, some stocks might fall due to fears of lower earnings. Meanwhile, government bonds might hold steady or even gain value as people look for safety. Issuer-specific news also can affect stock and bond prices, leading to gains and losses that are unrelated to broader economic conditions.

By holding various investments, gains in some of your holdings might offset losses in other holdings. As a result, your investing experience could be less volatile than if you only own stocks—or a handful of stocks with similar characteristics. Plus, you can choose how much risk to take, ranging from aggressive to conservative or somewhere in between.

There are three broad categories of investments: stocks, bonds and cash.

• Stocks offer the potential for growth, but they also are relatively risky and may experience large losses.
• Bonds tend to be more stable and pay income, and they can act as a stabilizer during volatile times. But bonds also can lose money due to economic conditions or issuer-specific events.
• Cash is a safe asset class for the most conservative investors, but it might lose purchasing power over time due to inflation.

These asset classes form the foundation of a portfolio, but it can be helpful to diversify further within each asset category. For example, your stock holdings might include large and small companies, but you also might invest in a mixture of foreign and domestic stocks. Likewise, your bond exposure could consist of different government and corporate bonds from around the world rather than one country or sector. (Note that while diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.)

The "right" mixture of stocks, bonds and cash depends on your needs and timeline, and every investor is different. In general, a higher allocation to stocks is a riskier approach designed to pursue long-term growth. As a result, those portfolios could see large losses periodically. But you might be rewarded for taking risks over the long term.

A bond-heavy portfolio would be less volatile in most market conditions, but rising interest rates or issuer defaults can cause losses in bond portfolios. That said, you can tailor your holdings to favor short-term, high-quality bonds, which might be less volatile than junk bonds or long-term bonds.

Some people question whether diversification is always the best course. The idea behind diversifying is that you don't risk significant exposure to a single sector or holding that may not pan out. You're aiming to have some investments that perform well to balance out any that don't.

But if you think you can predict which specific investments will outperform others, you might prefer not to diversify and instead have concentrated holdings in those areas. That approach can work well if you're right. It also can be problematic if things don't go as expected.

As with most financial decisions, your approach will depend on your situation, expertise and risk comfort level, but it's generally advantageous to explore all the types of asset allocation.

You can use asset allocation strategies with your portfolio in several ways. Strategically and tactically are two of the most common.

Strategic asset allocation is a long-term investing approach that typically stays the course regardless of market events. You might design a portfolio that's aligned with your goals, and major changes are rare.

Over time, you might adjust the holdings to reflect changes in your life (if you prefer to get slightly more conservative each year, for example). Still, you generally don't change course dramatically or move to the sidelines temporarily in response to market movements. However, you may need to rebalance the portfolio periodically to ensure that you maintain your desired allocations.

Tactical asset allocation is a more active strategy that may involve frequent changes to your holdings. Hypothetically, when you expect markets to perform well, you might add exposure to stocks or specific sectors. But if you think markets will fall, you might shift funds to cash or bonds. Of course, the success of this strategy depends on your ability to anticipate market movements, and is generally not recommended.

Your ideal asset allocation strategy will depend on your goals and your situation. A strategic allocation approach could make sense when you're willing to ride out the ups and downs. In that case, you'd set things up appropriately for your goals, and you would typically avoid major strategy changes when the markets move.

However, if you prefer a more active approach, tactical strategies could be a better fit. You might attempt to avoid losses and capture opportunities; just remember that this can be challenging and requires ongoing hands-on management.

Other factors can affect which strategy is optimal for you. If you're nearing retirement with very little saved, it may make sense to take more risk than somebody of a similar age who has a substantial amount to lose. But taking risks isn't always appropriate, nor will they always pay off—it depends entirely on your situation.

While you can't eliminate risk entirely, you can choose how much risk to take and adjust your allocation as your life changes. As investors in an ever-changing world, that's the best we can do. Still, it's wise to use tried-and-true approaches as you navigate uncertainty. To learn more about allocation strategies, speak with a financial advisor who can help you design a portfolio that's tailored to your needs.