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How Asset Allocation Funds Work

An asset allocation fund can help diversify investments and help protect against large losses like the one shown here.
Yoshikazu Tsuno/AFP/Getty Images

You want to save up for a home, college tuition or retirement. You know that to make your money grow you're supposed to invest it wisely, but what you may not know is how to actually do it. When it comes to investing, a good rule of thumb is to buy low and sell high. A low market makes for a perfect time to buy, but how low the market will go is an unknown variable. History has shown that the market will go up over time, but the thought of losing a significant amount of money before that happens can be enough to keep investors up at night.

Whether the market is high or low, bull or bear, investing can be a good way to make money over the long term. But how do you protect yourself against huge losses? An asset allocation fund might be the answer.

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Asset allocation funds are specific mutual funds that divvy up and distribute your money in different investments. Their goal is to generate consistent returns through diversified holdings. These funds divide investments among different asset classes [Source: InvestorWords]. While the reward from investing in this manner may not be as great as investing everything into that hot new stock, the risk is far less.

Still, the thought of putting your hard-earned money into today's markets can be scarier than any horror film playing at the multiplex. Read on to find out how asset allocation funds might make you less timid about investing.

Traders face a hard day on the Dow Jones, with the market closing low. Investing in an asset allocation fund can prevent such heavy losses.
Traders face a hard day on the Dow Jones, with the market closing low. Investing in an asset allocation fund can prevent such heavy losses.
Scott Olson/Getty Images

Asset allocation funds can make investing less frightening, but it's important to understand the specifics before investing in this or any type of fund.

Anyone can invest in an asset allocation fund, which may be part of your retirement portfolio, or among the 401(k) retirement options at your workplace [Source: Whelehan]. These funds often make the most difference during a bear market. When the market takes a significant, prolonged downturn, certain categories of stocks will plummet. If all of your investments happen to be in that grouping of stocks, you may suffer devastating losses [Source: Jenkins]. The variety of asset allocation funds can help balance out such losses through diversifying, or varying, investments.

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When you invest in an asset allocation fund, you have automatically diversified your investments into some combination of investment classes. Fund managers will usually further diversify investments within each investment class. For example, rather than buying only energy stocks, fund managers typically buy stocks in many fields, such as energy, technology, precious metals and pharmaceuticals. Likewise, an asset allocation fund will likely include different kinds of bonds and short-term reserves. Some funds might also include real estate or commodities.

­­But what type of fund is right for you? Before you invest in an allocation fund, you should consider what type of investor you are. Think about your comfort level with risk: Do you get so nervous when the market goes down that you sell all your stocks? Or are you willing to ride out the market's ups and downs? Also know what your investment window is. For example, if the goal of your fund is to pay for little Janie's college tuition and she's currently in second grade, your window is about ten years.

Questions like these can help you choose the type of asset allocation fund that's right for you. If you discover that you have a low tolerance for risk and a long window of time, you might want to choose a conservative or moderate fund. These funds typically contain fewer stocks and are therefore less risky, but sometimes less profitable, than more aggressive growth funds. Another point to consider is that some funds maintain a specific balance of funds over time, while others shift assets as conditions change.

Of course no investment, no matter how diversified or conservative, is guaranteed. Those seeking to invest should always consider their options carefully before investing.

­For more information on investing, visit the links on the next page.

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Sources

  • "Asset allocation funds." Charles Schawb. http://www.schwab.com/public/schwab/research_strategies/mutual_funds/funds/asset_allocation?cmsid=P-1387552&lvl1=research_strategies&lvl2=mutual_funds (Accessed 8/14/08)
  • "Asset allocation fund." InvestorWords.com. http://www.investorwords.com/276/asset_allocation_fund.html (Accessed 8/14/08)
  • "Examine your asset allocation." Vanguard. https://retirementplans.vanguard.com/VGApp/pe/pubeducation/retirement/Thinkingaboutretirement/investing/ExamineAssetAlloc.jsf (Accessed 8/20/08)
  • Jenkins, Richard. "Start investing with just $100." MSN Money. http://articles.moneycentral.msn.com/Investing/StartInvesting/StartInvestingWithJust100.aspx?page=all (Accessed 8/14/08)
  • Waggoner, John. "Are asset allocation or balanced funds for you?" USA Today. http://www.usatoday.com/money/perfi/columnist/netgains/2001-06-20-net.htm (Accessed 8/14/08)
  • Whelehan, Barbara. "Moving past 401(k) paralysis." Bankrate.com. http://www.bankrate.com/brm/news/boomerbucks/20051116a1.asp (Accessed 8/14/08)

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