Asset allocation refers to diversifying your investments among a combination of equities, fixed-income and cash equivalents.
I know -- that probably sounded like jargon. Stay with me.
An "asset" can be anything from your home to your right to collect royalties on a book that you wrote. But when people describe asset allocation, they're usually talking about money -- cash -- that you put in the market.
You use this money in three main ways: You buy companies. You give loans. Or you keep in in cash.
When you buy shares of a stock, you're buying "equities." When you buy a share of Apple stock, you become a part-owner of the company. You have "equity" in Apple.
If you don't want to buy a stock directly, you can buy a fund that holds a LOT of different stocks. Mutual funds and index funds, for example, are collections of lots of different types of stocks, bundled together in one convenient basket.
When you buy a bond, you're giving out a loan to whatever group "issued" (asked for) that bond. If you buy a corporate bond, for example, you're giving that company a loan. The company has to pay you interest on that loan. It has a "payment plan" on a fixed timeline. For example, it might pay you interest once a month, or once every three months.
That's why this is called a "fixed-income" investment: you get income on a fixed schedule.
Keep it in Cash
You can also keep your money in regular cash, which is easy to understand. Or you could put it into a Certificate of Deposit, which is an example of a cash equivalent.
So What is Asset Allocation?
Asset allocation means that you spread your money between a combination of equities, fixed-income and cash equivalents. Doesn't that make more sense now?
Sarah has $10,000. She decides to split her money into a combination of equities, fixed-income and cash.
First, she decides to put 60 percent of her money into equities. She further decides to split this between large companies like Coca-Cola and Reebok, and small companies that most people have never heard of. She buys $4,000 in index funds that track large-cap companies, and $2,000 in index funds that track small-cap companies. That's a total of $6,000, or 60 percent of her money, in equities.
She puts $3,500, or 35 percent, in fixed-income investments. She splits this 50/50 between U.S. Treasury bills and municipal (city) bonds.
Finally, she keeps $500 in cash, which she holds in a money market account.