Asset allocation is a key ingredient in a successful investment strategy. It refers to how your investment portfolio for a given goal is portioned out among various asset classes (investment categories).

Here are the most widely used asset classes and the risk-and-return profile of each, based on past performance:

• Cash equivalents include bank savings accounts, short-term certificates of deposit (CDs), US Treasury bills and money market funds. These pose the least risk but have also offered the lowest returns historically.
• Fixed-income investments are mainly bonds, bond funds and guaranteed insurance products like fixed annuities. These pose moderate risk and have historically yielded moderate returns.
• Equities, which are stocks and mutual funds, present the most risk but offer the highest potential returns of the three main asset classes.

Your portfolio for any given goal should reflect an asset allocation that's tied to your time horizon (how much time you have to achieve the goal), the level of return you'd like to get and your tolerance for risk. Short-term goals (one to three years away) call for an asset allocation that poses low risk, even though it may also produce a low return. For medium-term goals (three to seven years away), a moderate-risk, moderate-return allocation is appropriate. For goals that are seven or more years away, which may include things like retirement or sending your child to college, you might choose an allocation that poses greater risk but offers the potential for a higher long-term return.

Stay in touch with your asset allocation

Once you've set up an asset allocation for your portfolio, be sure to review the allocation at least once every 12 months, or whenever you go through a major life event, like getting married or divorced or adding a child to your family. If the goal for which you created the portfolio has changed, you may want to change the allocation accordingly.

As the time horizon for a longer-term goal shortens, you might consider taking on less risk with your portfolio. For example, investing for education or retirement typically involves gradually moving toward a more conservative asset allocation (less reliance on stocks, more reliance on cash equivalents and bonds) as the goal draws nearer.

Rebalancing

Different assets produce different investment results. So, over time, your portfolio may drift away from the asset allocation you want. This can happen even if you continue to invest according to plan and don't withdraw from your investments or transfer assets among them. Before too long, assets growing more quickly will take up more room in your portfolio than you want, while assets with less robust performance will play a smaller role than you'd like.

To address such a natural shift, you can rebalance your portfolio. This means moving balances among investments to return to your intended asset allocation.

Suppose you started out with an allocation of 60% stocks/40% bonds. Since then, your bonds have performed a lot better overall than your stocks, and you've ended up with a mix of 35% stocks/65% bonds. To get back to your original 60/40 mix, you can transfer some balances from bonds to stocks.

Typically, you'll incur current year taxes on any gains realized when you transfer balances within an investment account that is neither tax-deferred, like a 401(k) or 403(b) account, nor tax-free, like a Roth IRA (in most cases). To avoid this triggering of taxes, you could rebalance gradually by changing the investment direction of future interest, dividends and capital gains on the account as well as new contributions to the account. You could also sell some "losers" at the same time, recognizing that capital losses offset capital gains. Up to $3,000 ($1,500 if you're married and filing separately) of excess capital losses are deductible against ordinary income each year.

You can get professional and unbiased one-on-one guidance on asset allocation by calling an Ernst & Young LLP (EY) financial planner.

This material is provided solely for educational purposes; it does not take into account any specific individual facts and circumstances. It is not intended, and should not be relied upon, as tax, accounting, or legal advice.