The importance of asset allocation
There are three main types of asset classes: equities, fixed income and cash (or cash equivalents). How much money you allot to each asset class is typically based on your financial goals, risk tolerance and the length of time you plan to hold those investments.
Asset allocation can have a significant impact on your ability to achieve your financial goals. For example, if your asset mix is too conservative – thanks to an insufficient weighting to equities – you might compromise the growth potential of your portfolio.
Equities are considered to be a riskier asset class, but they also tend to offer the strongest potential for long-term growth. The growth of equities is usually in the form of capital gains and dividends – both of which are taxed at a lower rate than the interest income offered by fixed-income investments.
Fixed-income investments – which include corporate and government-issued bonds, guaranteed investment certificates (GICs), and other types of interest-paying securities – tend to be less volatile than equities, but also tend to offer lower long-term return potential. Beyond paying interest, fixed-income securities may also rise or fall in value for a number of reasons, including changes to central bank interest rate policies, specific government or corporate events, the outlook or strength of the issuer (as well as any changes to their credit rating), and the wider macroeconomic environment.
Cash and cash equivalents (such as treasury bills and money-market securities) are considered the safest asset class. They are typically used for capital preservation, as they offer modest interest income and no potential for growth. After accounting for tax paid on any interest, as well as the impact of inflation, cash or cash equivalents offer little in the way of gains.
Below is an example of an asset mix for a mutual fund.
Although asset allocation is a core component of any long-term investment strategy, many individuals don’t have the time or expertise to create an asset mix that suits their specific investor profile and can meet their long-term financial needs. That's another reason why it’s so important to work with a financial advisor.
The contents of this piece are not to be used or construed as investment advice or as an endorsement or recommendation of any entity or security discussed.