Simply put, asset allocation is the amount of stocks vs. bonds you own.
Stocks have the potential for higher returns, but also carry a higher level of risk. Bonds generally provide lower returns, but also carry a lower level of risk. The key is to find the appropriate mix of stocks vs. bonds based on your personal financial situation--your specific needs, objectives, goals and tolerance for risk.
So, if you want the potential for higher returns, your asset allocation would contain more stocks and less bonds. For example, 90/10, which means 90% stocks and 10% bonds.
Here’s how this relates to the "gap" we’ve been talking about recently:
Say you had the abovementioned 90/10 asset allocation in 2008 (the recent "Great Recession") and by the end of 2008 your 90/10 investment portfolio was down between 35-40% (which was very likely for a 90/10 portfolio in 2008). At that point, would you have been tempted to sell to preserve what was left of your portfolio, for fear the market was going to continue to go down… -45%? -50%?If you’d have been tempted to sell after experiencing that large type of downturn, that suggests, perhaps, that a 90/10 asset allocation is not appropriate for your personal financial situation. Maybe a 70/30 asset allocation is more suited to you. Or even
60/40. Remember, the more bonds you add to your portfolio (the /30 or /40 in the previous sentences), the smoother the ride will be.
Now simply adding more bonds to your portfolio doesn’t mean you’ll completely avoid experiencing negative returns from time to time, but it does mean your downturns should be less dramatic than someone with 100% of their investments in stocks.
The goal is to find an asset allocation that is comfortable for you and that will allow you to "stay the course throughout market downturns. If you can simply do that, you’ll be doing your part to erase the "gap"!