Asset allocation just means not keeping all your eggs in one basket.
Let's say you want to go to Harvard. You buy the snappy sweatshirts, get a "Harvard or Bust" bumper sticker on your car, and go to bed every night dreaming of ivy-covered walls. You don't apply anywhere else…and then your rejection letter comes in. You don't have any back-up plans, so…no college for you.
With investments, you also want to have backup plans. One way to do that is to make sure your assets and investments are spread out a little. Rather than sinking all your money into just stocks (or just bonds) or investing only in one area (like real estate or tech), you want to make sure that your money is distributed across different types of investments and different industries. That way, if the stock market tanks or the tech sector drops through the floor, you haven't lost everything.
How to Allocate Your Assets
There are about a million different ways to allocate your assets so that your money is a little safer.
One way is just to mix up investments so that you have some more secure investments and some riskier investments. If you've been Shmooping your finances, you already know that when something has a higher risk, there is likely a larger payoff. And when something gives you less risk and surer cash, the payout will be smaller. With stocks, for example, you're buying a tiny piece of the company. If the company fails, you're out the money, so there's a higher risk. If the company does well, though, you're going to earn money (possibly a lot of it) from your investment.
In the long term, stocks tend to earn you more, but they go through a lot of ups and downs, which can be scary. When you buy bonds, on the other hand, you're buying a piece of a company's debt. The company promises to pay you back and to pay you a specific interest rate every year. There's still some risk if the company goes under, but the risk is a lot lower. So no surprise here: your possible returns are much smaller. Even if the company does amazeballs, you're only going to get the few percent in interest the company promised you.
So if you're investing in stocks and bonds, you're going to want to make sure that you have some of each so they even each other out. Just like a perfectly balanced playlist, your investments should have some raise-the-roof investments that get your blood pumping and some more mellow investments to cool the vibe.
There are a few ways you can make sure your assets have a nice mix:
Consider your age.
Most money experts agree that the younger you are, the more you should invest in stocks and other higher-risk investments. Money experts rarely agree on anything, so this is one case where we might want to listen up. The younger you are, the more you can hold on when the market tanks, giving the market a chance to bounce back. Since you'll probably be working for a long time at this stage, anything you invest now will only be a tiny piece of how much you make overall (we hope), so you want that money growing fast.
Mutual funds and index funds can be an easy way to mix up investments. The friendly folks who create these investments create a mix for you, so you don't have to spend a lot of time figuring out where to invest.
Make sure you have some long-term growth and short-term growth investments.
A good bet is to have some bonds with maturity dates in the next few years and some stocks you want to hold onto until you're grey and even Botox can't cover the wrinkles.
Consider your risk comfort level.
Ever been to a party well outside your comfort zone? Not very fun. It's the same with investments. You need your beauty sleep, and you don't want to be kept awake at night wondering what your investments are up to.
Create an emergency fund.
Cash is also an asset, and you want to have some in a savings account so you don't have to dip into your investments if your car needs a new muffler or your dog needs to go to the vet because he swallowed $2.50 in quarters.