Asset allocation means spreading your investment funds across many asset categories. As an investment strategy, this will help the investor balance the overall portfolio risk, volatility, and performance. Asset allocation is an important construct to use when designing a portfolio. The goal is not picking or choosing specific securities, instead it is a focus on the overall architecture or broad investment categories that will ultimately mix together to help you meet your financial goals by factoring in your risk tolerance and time horizon.
Asset Allocation basics
The main idea behind asset allocation is that since not all investments follow a similar cycle, you are able to balance out the different risk and return cycles in your portfolio by spreading your investment dollars among different asset classes such as stocks, bonds, real estate, commodities, and other assets. It certainly doesn’t guarantee a profit or protect you against losses, but it can help you manage the amount of risk you face.
Different types of asset classes bring different levels of risk and potential for return to a portfolio, and they generally react to different market forces in their own ways and possibly at different times. The effects of a real estate market may hit the real estate sector first but perhaps affect the stock market at a later time. So while the returns of one asset class may be declining, another asset class may be growing. If you diversify your portfolio to include many different types of assets, a market downturn or swing in one asset won’t necessarily wreak havoc on your entire portfolio.
Your financial advisor can help identify the types of asset classes that may be appropriate for your specific investment objectives and risk tolerance, and then allocate funds to each class say 70% to stocks, 20% percent to bonds, and 10% to real estate).
The major asset classes
Below are the three major asset classes you’ll generally take advantage of when creating an asset allocation.
Stocks: Stocks have historically provided investors with a higher average annual return than other types of investments such as bonds or cash alternative. Needless to say, because of their potential for higher returns, stocks are typically more volatile and carry a greater degree of risk than other asset classes such as bonds and cash alternative. Investment in stocks may be suitable for those investors that have a longer investment time horizon.
Bonds: As mentioned earlier, bonds have historically been less volatile than stocks. Bonds do not provide opportunity for capital appreciation that stocks can potentially provide. However, they may be appropriate for investors looking for a fixed and stable income stream from their investments. In addition, bonds carry interest rate risk with them. When interest rates rise, bond values tend to fall, and when interest rates fall, bond values tend to rise.
Cash alternatives: Do not provide much capital appreciation potential or income potential but are the least volatile and risky of the three major asset classes. Nevertheless, they are subject to inflation risk. They are generally highly liquid investments and provide investor with easier access to funds than longer-term investments such as stocks and bonds. Cash alternatives may be suitable for investors with short-term investment goals.
Not only is asset allocation a tool to diversify across different asset classes such as purchasing stocks, bonds, and cash alternative, but you can also diversify within each asset class. For instance, when you invest in stocks, you can invest in large-cap stocks that tend to be less risky than small-cap stocks. Or you can further divide your funds according to different investment styles such as for growth, for value, or for income. Certainly you can have an endless combination of investment possibilities, but the objective is the same – diversify your investments by choosing investments that balance out the risk and returns within your portfolio.
Decide how to divide your assets
The main objective in using asset allocation is to design a portfolio that can potentially give you the return you want while reducing the amount of risk you’re exposed to or that you feel comfortable with. Your investment time horizon is critical too, because the longer your time horizon, the more time you have to ride out market ups and downs.
Your Financial Advisor can help you construct a portfolio and factor in your investment objectives, your risk tolerance, and your investment time horizon. Subsequently, your financial advisor will suggest model allocations that strike a balance between your expected risk and your expected return.
For example, if your are looking to retire in the next 30 years and you can tolerate a relatively higher degree of risk, a model allocation may suggest that you put a larger percentage of your funds in stocks and a smaller percentage into fixed-income instruments such as bonds or cash alternative. Models serve as good guidelines, but your financial advisor will help you determine the right allocation for your individual situation.
Build your portfolio
After you come to a decision on your overall asset allocation, you will then need to choose investments for your portfolio that match your asset allocation strategy. If, like most investors, you don’t have the expertise or the time to build a diversified portfolio of securities, you may want to consider investing in mutual funds.
Mutual funds can offer diversification within different asset classes. Each fund is managed according to a specific investment objective, making it easier to identify funds that are aligned with your investment goals. For example, you may see some funds with investment objectives of capital preservation, income, income and growth, growth, or aggressive growth.
Pay attention to your portfolio
Once you have chosen your portfolio with your initial asset allocation strategy, make sure to revisit your portfolio consistently. One main reason is to make sure that your current investments are still in line with your investment objectives and market expectations. Also, it may be necessary to rebalance your portfolio from time to time to make sure you maintain your original asset allocation. For example, if the stock market is doing well, you will see that you portfolio will eventually become more overweighed on the stocks side than you initially intended. To rebalance, you may have to shift investment dollars from one asset class to another.
At times you may want to adjust your entire allocation strategy. For example, if you are not comfortable with the level of risk your initial asset allocation strategy exposed you to or your financial goals changed, you may need to compose a new asset mix.