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A Guide To Asset Allocation

A Guide To Asset Allocation

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Introduction

Here is a helpful guide if you still have not completely understood asset allocation.

Have you given your investment portfolio any thought? Every investment portfolio must include a variety of asset classes in order to maintain some level of balance.

This is comparable to the proverb “don’t put all your eggs in one basket” The asset allocation tenet also holds true for investments in mutual funds.

What Is Asset Allocation?

Asset allocation is a type of investment strategy that divides up a portfolio’s assets according to a person’s objectives, risk tolerance, and investment horizon in order to balance risk and reward.

Equities, fixed-income, and cash and equivalents, the three major asset classes, all have varying levels of risk and return, which will cause each to behave in a unique way over time.

How Important Is Asset Allocation?

Different asset classes move in various directions. Asset classes rarely perform in unison. In order to time the market, it might be thought that it is best to invest in mutual funds that are performing exceptionally well at the moment.

To predict the direction in which any asset class will move at any given time, however, can be very difficult for anyone.

For example, when stocks are rising, gold investments may decline, and vice versa. As a result, spreading investments across a variety of asset classes makes sense.

By doing this, the underperformance of one set of asset classes or funds will be offset by the performance of the other asset classes. It can be extremely risky to invest all of one’s money in a single asset class or mutual fund strategy.

However, investors typically generate better returns if their wealth is spread across a variety of asset classes.

A Guide To Asset Allocation
Example of Asset Allocation. Image from Scripbox.

How Does Asset Allocation Work?

Investors should diversify their investments across different asset classes, according to financial advisors’ usual advice, to lower the volatility of portfolios.

Because different asset classes will always have varying returns, this straightforward logic explains why asset allocation is a popular practice in portfolio management. In this way, investors will get a shield to protect them from the decline of their investments.

What Is Asset Allocation Funds?

An asset allocation fund is a type of investment vehicle that offers investors a diversified portfolio of holdings in a range of asset classes.

The fund’s asset allocation can be either fixed or variable among a variety of asset classes, which means that depending on the state of the market, it may be allowed to be overweight in some asset classes or held to fixed percentages of all asset classes.

Example Of Asset Allocation

Let’s imagine that Joe is putting together a financial strategy for his retirement. He therefore intends to invest his $10,000 savings over a five-year period.

As a result, Joe’s financial advisor might suggest that he diversify his portfolio by splitting it 50/40/10 between stocks, bonds, and cash. His resume might appear as follows:

  • Stocks
    • Small-Cap Growth Stocks – 25%
    • Large-Cap Value Stocks – 15%
    • International stocks – 10%
  • Bonds
    • Government bonds – 15%
    • High yield bonds – 25%
  • Cash
    • Money market – 10%

Therefore, the allocation of his investment among the three major categories could be as follows: $5,000/$4,000/$1,000.

What Is The Process Of Asset Allocation?

Your equity holding should be equal to 100 less your age, according to one of the most popular asset allocation rules by thumb. In other words, if you’re 40, you could invest 60% in equity and the other 40% in debt. A Rule of 110 exists as well and functions similarly.

But these are only guidelines. Risk tolerance is the aspect that one needs to consider when investing.

In addition to considering your age, you would also need to consider your financial objectives, net worth, earning potential, and obligations before making a decision. The time horizon that you want to keep investing in would also need to be considered.

Aside from being the simplest way to achieve asset allocation, mutual funds already include a component of diversification.

Even within an asset class, you can achieve some degree of diversification; for example, if you invest in equity mutual funds, you could choose one that has a mix of holdings in small, large, and mid-cap companies.

What Are The Factors That Can Affect Asset Allocation?

Selecting the ideal asset mix for your portfolio is a very personal decision. Asset allocation decisions are influenced by a number of variables, including an investor’s investment horizon, risk tolerance, and personal financial goals and objectives.

Let’s examine the following variables:

1. Time Horizon

The time horizon component is affected by how long an investor intends to hold an investment. It largely depends on the investment’s objective. The risk tolerance associated with various time horizons varies similarly.

In light of the uncertain nature of economic dynamics and the possibility that they could shift in the investor’s favor, a long-term investment strategy, for instance, may encourage an investor to invest in a more volatile or high-risk portfolio.

Short-term investors, however, might not want to put money into riskier portfolios.

2. Risk Tolerance

An investor’s willingness and capacity to lose some or all of their initial investment in the hope of higher potential returns is referred to as risk tolerance.

Investors who are aggressive or who have a high-risk tolerance are likely to put most of their money at risk in order to receive better returns. Contrarily, risk-averse or conservative investors are more likely to invest in securities that protect their initial capital.

3. Risk and Reward

Risk and reward are intrinsically linked when it comes to investing. The saying “no pain, no gain” is probably one you’ve heard before; it pretty much sums up how risk and reward relate to one another. Nobody should try to convince you otherwise.

Risk is a component of all investments. Before making an investment, it’s critical to understand that you could lose all of your money if you decide to buy securities, such as stocks, bonds, or mutual funds.

The potential for a higher investment return is the reward for taking on risk. If you have a long time horizon for your financial goal, carefully choosing riskier asset classes like stocks or bonds will likely yield a higher return than limiting your investments to safer assets like cash equivalents.

However, for short-term financial objectives, investing only in cash investments may be appropriate.

Investment Options For Asset Allocation

Despite the fact that the SEC is unable to endorse any specific investment product, you should be aware that there are a wide variety of investment options available, including stocks and stock mutual funds, bond mutual funds, corporate and municipal bonds, lifecycle funds, money market funds, exchange-traded funds, and U.S. federal government debt.

Investing in a combination of stocks, bonds, and cash may be a wise course of action for achieving many financial objectives. The traits of the three main asset categories will be examined in more detail now.

1. Stocks

Historically, of the three main asset categories, stocks have had the highest returns and the highest risk. Stocks are the “heavy hitter” of asset classes in a portfolio because they have the highest growth potential.

Stocks can strike out as well as hit home runs. Stock investments are very risky in the short term due to their volatility. For instance, the average loss for large company stocks has been about one out of every three years.

And in some cases, the losses were quite severe. However, those investors who have been prepared to endure the erratic stock returns over extended periods of time have typically been rewarded with significant gains.

A Guide To Asset Allocation
Stocks. Image from TIME.

2. Bonds

Although they provide more modest returns than stocks, bonds are typically less volatile. Due to the lower risk of holding more bonds, despite their lower potential for growth, an investor who is close to reaching a financial goal may increase their bond holdings relative to their stock holdings.

Keep in mind that some types of bonds offer high returns that are comparable to stocks. But the risk is higher with these bonds, also referred to as junk or high-yield bonds.

3. Cash

The safest investments are cash and cash equivalents, which include savings deposits, treasury bills, certificates of deposit, money market funds, and money market deposit accounts. 

However, these assets have the lowest returns of the three main asset classes. Investments in this asset class typically have very low chances of losing money. Many cash-equivalent investments are backed by the federal government.

Although rare, investment losses in non-guaranteed cash equivalents do happen. For investors who purchase cash equivalents, inflation risk is their main worry. This is the chance that, over time, inflation will outpace investment returns and reduce them.

The most popular asset types are stocks, bonds, and cash. These are the types of assets that you would probably pick from when investing in a college savings plan or a retirement savings program.

Nevertheless, there are other asset classes as well, such as precious metals, real estate, and other commodities, and private equity, and some investors may include these class of assets in a portfolio. The risks associated with investments in these asset classes are frequently category-specific. Before making any investment, you should be aware of the risks involved and make sure they are suitable for you.

6 Strategies For Asset Allocation

There is no set method for investing in asset allocation, and every financial advisor has their own strategy. The top two methods for influencing investment choices are as follows.

1. Age-Based Asset Allocation

Age-based asset allocation bases investment choices on the investors’ ages. As a result, the majority of financial advisors advise clients to base their stock investment choice on subtracting their age from a base value of 100.

The amount is based on the investor’s expected lifespan. The percentage of investments made in riskier fields, like the stock market, increases as life expectancy increases.

Example of Age-based Asset Allocation

Let’s pretend that Joe, from the previous example, is now 50 years old and that he is eager to retire at age 60.

The advisor might suggest that he invest 50% of his money in stocks and the remaining 50% in other assets, in accordance with the age-based investment approach. This is so that you can calculate his age (50), which is equal to 50 when subtracted from a base value of 100.

2. Life-Cycle funds Asset Allocation or Targeted Date

According to their investment objectives, risk tolerance, and age, investors can maximize their return on investment (ROI) by using life-cycle funds allocation or targeted-date strategies. 

Because of problems with standardization, this type of portfolio structure is complicated. In actuality, each investor has particular variations among the three factors.

Example of Life-Cycle Funds Asset Allocation or Targeted Date

Let’s say Joe invested 50/50 at the beginning. His risk tolerance for stocks may rise to 15% after a five-year time horizon.

He could therefore sell the 15% of his bonds and reinvest the money in stocks. It will now be 65/35. Based on the three variables of age, risk tolerance, and investment goals, this ratio may continue to change over time.

3. Tactical Asset Allocation

The difficulties that arise from strategic asset allocation in relation to long-term investment policies are addressed by the tactical asset allocation strategy.

Tactical asset allocation therefore aims to enhance short-term investment strategies. So that investors can invest in assets with higher returns, it adds more flexibility in adjusting to market dynamics.

4. Constant-Weight Asset Allocation

The buy-and-hold policy is the foundation of the constant-weight asset allocation strategy. In other words, when a stock’s value drops, investors buy more of it.

They sell a larger portion, though, if the price rises. The objective is to make sure that the ratios never deviate from the original mix by more than 5%.

5. Dynamic Asset Allocation

The most well-known kind of investment strategy is dynamic asset allocation. The market’s highs and lows as well as the economy’s gains and losses can be used to adjust how much money investors are investing in each asset class.

6. Insured Asset Allocation

The insured asset allocation is the optimal approach to take for investors who are risk averse. It entails establishing a base asset value below which the portfolio shouldn’t deviate.

In case of a decline, the investor takes the necessary steps to mitigate the risk. If not, they can buy, hold, or even sell as long as they can get a value that is just a little bit higher than the base asset value.

Benefits Of Asset Allocation

1. Diversification

Since investing in various classes is a component of asset allocation, diversification is a crucial component that helps to lower risks.

You won’t be severely impacted by risks inherent in one risk type because market forces or the economy have different effects on different asset classes.

If all of your money were invested in stocks, you would have to forfeit it all if the stock market crashed like it did in 2008. You would have benefited from debt/fixed income investments’ advantages and been shielded from the risk that comes with investing in stocks if you had done so.

How Diversification Works

Diversification is the process of allocating funds among various investments to lower risk. Without giving up too much potential gain, you might be able to limit your losses and lower the fluctuations of your investment returns by choosing the right group of investments.

Additionally, asset allocation is crucial because it greatly affects your likelihood of achieving your financial objectives. Your investments might not generate a sufficient return to reach your objective if you don’t take on enough risk in your portfolio. For instance, the majority of financial experts concur that you should likely include at least some stocks or stock mutual funds in your portfolio if you are saving for a long-term objective, such as retirement or college.

The money for your goal might not be available when you need it if, on the other hand, your portfolio contains too much risk. For a short-term objective like saving for a family’s summer vacation, a portfolio heavily weighted in stocks or stock mutual funds, for example, would be inappropriate.

2. Long-Term Investing

You can think long-term and avoid basing your investments on transient market volatility by using asset allocation. Your investments are less significantly impacted by market fluctuations because your portfolio adheres to the asset allocation principle.

3. Discipline

There is a degree of discipline in your investing because you think long term and have diversified your portfolio. Focusing on your goals and the assets that will help you achieve them is made easier by asset allocation.

4. Better Returns

Diversification means that you are more likely to outperform a portfolio with just one asset class if you are exposed to a variety of asset classes over the long term. This is accomplished by protecting your portfolio from market declines in one asset class by diversifying your holdings.

How To Get Started With Asset Allocation

It is difficult to choose the right asset allocation strategy for a given financial objective. In essence, you’re attempting to select a portfolio of assets that has the best chance of achieving your objective at a level of risk you can tolerate. You’ll need to be able to modify the mix of assets as you near your goal.

You might feel at ease developing your own asset allocation model if you have a clear understanding of your time horizon and risk tolerance, as well as some investing experience. 

You can get assistance from a number of online resources and general “rules of thumb” discussed in “how to” books on investing. For instance, the Iowa Public Employees Retirement System provides an online asset allocation calculator, even though the SEC is unable to recommend any specific formula or methodology.

You’ll ultimately make a decision that is very personal to you. There isn’t a single asset allocation strategy that is suitable for all financial objectives. The one that is best for you must be used.

Some financial experts think that choosing your asset allocation is the most crucial choice you’ll make regarding your investments—perhaps even more crucial than the specific investments you choose to purchase. In light of this, you might want to think about asking a financial expert to assist you in deciding your initial asset allocation and to offer suggestions for future adjustments.

However, make sure to conduct a thorough background check on the applicant’s credentials and disciplinary history before you hire them to assist you with these extremely crucial decisions.

A Guide To Asset Allocation
Diversification and Asset Allocation. Image from Kubera.

The Relationship Between Diversification And Asset Allocation

Spreading your money among a variety of investments is a strategy that can be succinctly summarized by the adage, “don’t put all your eggs in one basket,” with the idea being that if one investment loses money, the other investments will more than make up for those losses.

Asset allocation is a popular strategy used by investors to diversify their holdings across different asset classes. Other investors, however, purposefully don’t.

For instance, investing exclusively in stocks in the case of a 25-year-old investing for retirement or exclusively in cash equivalents in the case of a family saving for a down payment on a home could, in certain situations, be considered reasonable asset allocation strategies.

However, neither strategy makes an effort to lower risk by holding a variety of asset classes. Therefore, picking an asset allocation model won’t guarantee portfolio diversification.

Depending on how you distribute the funds in your portfolio among various investment types, you can determine whether your portfolio is diversified.

The Basics Of Diversification

Two levels of diversification are necessary for a well-balanced portfolio: within and between asset classes.

You will therefore need to distribute your investments within each asset category in addition to dividing them among stocks, bonds, cash equivalents, and possibly other asset categories. The secret is to pinpoint investments in each asset category’s subsets that might behave differently depending on the state of the market.

Finding and investing in a wide range of businesses and industry sectors is one method of diversifying your investments within an asset category. If you only invest in four or five individual stocks, for instance, the stock portion of your investment portfolio won’t be well-diversified. A minimum of a dozen carefully chosen individual stocks are required for true diversification.

Because diversification can be so difficult to achieve, some investors may find it simpler to diversify within each asset class by owning mutual funds rather than by making individual investments from each asset class.

A mutual fund is a business that collects money from numerous investors and invests it in securities such as stocks, bonds, and other financial products. Investors can easily own a small percentage of a variety of investments through mutual funds.

For instance, an index fund for the entire stock market holds shares of thousands of businesses. One investment has a ton of diversification!

Keep in mind, though, that investing in a mutual fund may not always result in immediate diversification, particularly if the fund only focuses on a single industry sector. To achieve the desired diversification if you invest in closely focused mutual funds, you might need to invest in multiple mutual funds.

That might entail taking into account various small- and international-company stock funds in addition to some large-company stock funds within asset classes. That might entail taking into account money market funds, bond funds, and stock funds among other asset classes.

Of course, as you increase the number of investments in your portfolio, you’ll probably incur more costs and fees, which will reduce your investment returns. Therefore, when determining the best way to diversify your portfolio, you must take these costs into account.

When To Change Your Asset Allocation

Your time horizon may have changed, which is the most frequent cause for changing your asset allocation. To put it another way, you’ll probably need to adjust your asset allocation as you approach your investment goal.

As they approach retirement age, for instance, most investors who are saving for their future typically hold less stock and more bonds and cash equivalents.

If your risk tolerance, your financial situation, or the financial goal itself changes, you might also need to adjust your asset allocation.

Smart investors, on the other hand, rarely alter their asset allocation in response to the relative performance of different asset classes, such as by boosting the percentage of stocks in their portfolios during a bull market. Instead, they “rebalance” their portfolios at that time.

The Basics of Rebalancing

Rebalancing means returning your portfolio’s asset allocation to where it was before. This is essential because eventually some of your investments might stop supporting your financial objectives.

Your investments may grow more quickly in some cases than others. By rebalancing, you’ll make sure that your portfolio doesn’t place an excessive emphasis on one or more asset classes and you’ll bring it back to a risk level that is comfortable for you.

Let’s say, for instance, that you decided that stock investments ought to account for 60% of your portfolio. However, stock investments now make up 80% of your portfolio following a recent stock market rise.

If you want to get back to your original asset allocation mix, you’ll either have to sell some of your stock investments or buy securities from an underweighted asset class.

Examining the investments within each asset allocation category is another step you must take when you rebalance. You will need to make adjustments to return any of these investments to their initial allocation within the asset category if they are not in line with your investment objectives.

Rebalancing your portfolio can be done in essentially three different ways:

  • You can sell investments in overexposed asset classes and use the money raised to buy investments in underexposed asset classes.
  • For underweighted asset classes, new investments can be bought.
  • If you are consistently adding to the portfolio, you can adjust your contributions to include more funds in underweighted asset classes until the portfolio is once again in balance.

You should think about whether the rebalancing method you choose will result in transaction fees or tax repercussions before you decide to rebalance your portfolio. You can reduce these potential costs by finding strategies with the assistance of your tax or financial advisor.

When To Consider Rebalancing

Your investments or the calendar can both be used to rebalance your portfolio. A lot of financial professionals advise investors to rebalance their portfolios on a regular basis, such as every six or twelve months.

The benefit of this approach is that the calendar serves as a reminder of when you ought to think about rebalancing.

Others advise rebalancing only when an asset class’s relative weight shifts in either direction by more than a predetermined threshold.

The benefit of using this strategy is that your investments will advise you when to rebalance. In either scenario, rebalancing usually functions best when done on an infrequent basis.

Final Thoughts

The idea of “one size fits all” does not apply to asset allocation. Each person’s financial situation is different and necessitates a special strategy.

Investors should actually regularly review their financial strategies to make sure they are in line with their financial objectives, risk tolerance, and time horizon. Never forget that portfolios with a strong product selection and reliable asset allocation typically outperform the market. You might think about hiring a professional if you are unsure of the optimal asset allocation to achieve your goals.

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Adam is an internationally recognised author on financial matters, with over 739.2 million answer views on Quora.com, a widely sold book on Amazon, and a contributor on Forbes.

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