Many investors use an asset allocation strategy to create a varied portfolio of investments. A standard asset allocation model divides securities into three main groups: cash, bonds and stocks. Your risk tolerance and your investment time horizon usually dictate the exact makeup of your portfolio of assets.
Within investment circles, the word "cash" is used when referring to liquid, low-risk securities such as money market mutual funds and certificates of deposit. Generally, cash securities are not subject to principal fluctuations and provide you with steady but modest returns. Bonds typically offer higher yields but are only worth something if the bond issuer remains solvent. Stocks offer no principal protection at all but provide you with unlimited growth potential. The value of a stock rises and falls in line with the value of a particular company.
An ultraconservative investor is primarily concerned with principal protection. Therefore, conservative investors tend to invest the bulk of their money in cash securities. An aggressive investor is primarily concerned with growth, and her aggressive allocation model usually contains mostly stocks. Moderate allocation models often contain significant quantities of bonds, which aren't as risky as stocks but offer better returns than cash securities. Regardless of their primary objective, many investors allocate their holdings among all three classes of assets. For example, an aggressive investor may mitigate principal risk by holding a small amount of cash and bonds.
The longer your time horizon, the more chance you have to recoup your losses. Consequently, young investors often invest heavily in stocks because they can endure market downturns and still have time to recover their losses. People near retirement have more to lose and typically shift their assets away from stocks and into income-generating bonds or cash. Conservatively minded long-term investors must contend with inflation risk -- inflation growing at a rate that exceeds the rate of return on an investment. Inflation risk is less of a concern for those with a short-term investment time horizon.
You can create your own asset allocation portfolio by acquiring individual securities. However, actively managing your assets can prove time consuming. Mutual fund companies simplify the issue by offering various asset allocation models. You select a model that best suits your needs, and the fund manager handles the trading. Many mutual funds are automatically rebalanced every month or quarter. This means the fund manager buys and sells assets if price increases or decreases cause the overall percentage of cash, bonds and stocks to change.