What Is Asset Allocation and How Does It Help Build Long-Term Wealth?

Here are the basics on what asset allocation is, how it works, and how it plays a role in your quest to build wealth.
Asset Allocation

So maybe you’re a champ on budgeting, have mastered tracking your spending, and are in the habit of visualizing your spending. You’re now eager to get into the nitty-gritty on how to create a small army of money-making vehicles for the long run.

One part of building wealth is having a basic understanding of asset allocation, or how to create a spread or mix of your investments so you can ultimately get the most bang for your buck. While this concept may at first seem befuddling, it’s really not as complicated as it sounds. Here are the basics on what asset allocation is, how it works, and how it plays a role in your quest to build wealth.

What is asset allocation?

When it comes to investing in the stock market, there are three main types of assets or types of investments: stocks, bonds, and cash equivalents. You can think of cash equivalents as investments that are easy to convert to cash, or have high liquidity and include assets such as U.S.-government-backed bills or CDs from a bank.

Each of the different types of assets has varying levels of risk and return. For instance, while stocks are considered the most risky, they also have the most potential for growth for the long term. Bonds, on the other hand, while considered the least risky, have the least potential for growth.

Asset allocation is a strategy used primarily in the investing world. It means a mix of the three to help guard you against risk and the volatility of the market. In figuring out the right mix of investments, factors that come into play include the time frame you have to invest and your comfort level with taking on risk.

Why do it?

A common analogy used with asset allocation is having all your eggs in one basket. It’s conventional wisdom not to put all your eggs in one basket because if a creature such as, say, a distracted dog or intrepid dinosaur trampled all over this metaphorical basket, you’d be out of luck. But if you had some eggs in one basket while others were safely tucked away, you’d be much better off, as your risk would be more spread out.

How does time play into asset allocation?

Time also plays a big part in what kind of mix you want to create with your assets. For instance, if you have 40 years to invest, you can afford to be more risky than if you only have, say, 10 years to invest in the market. If you have 40 years to invest, you’ll have way more in stocks than if you only had 10 years left. The more time you have to invest, the more time you’ll have to weather the ups and downs of the market.

To make sure you hit your goal by the set deadline or target date, as you get closer to the date you’ll want to have a mix, or asset allocation, that veers toward being less risky. For example, you’ll usually have fewer stocks, which are well and good if you have more time on your hands, and more bonds, which are less risky.

How does it help build wealth?

Asset allocation is a time-tested strategy to protect against the risk that comes with investing in the stock market. Think of it as something to add to your toolkit in developing a money mindset to build wealth. It’s definitely not something that will make you rich overnight; it’s used for building wealth for the long run.

While you might think you should invest in what makes the most money at the time, you’ll most likely eventually crash and burn because the cliché “what goes up must come down” holds true, especially if you’re in it for the long run. Because you’re adjusting your mix of investments to account for different factors such as time and your comfort level with risk, asset allocation will help you maximize your returns.

Thinking big picture and understanding basic investing principles will help you level up in your financial wellness and create wealth down the line.

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