Financial assets, such as equities, fixed-income, and cash, all behave differently over time. So how can you balance the risk and reward of different asset classes in your portfolio according to your personal goals, risk tolerance, and investment horizons? The answer may lie in a little investment strategy called asset allocation.
What is asset allocation?
Asset allocation is a strategy that is concerned with accumulating wealth needed by investors to meet their needs and aspirations. It aims to manage risk through diversification, and its effectiveness primarily depends on your time horizons and risk tolerance.
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Compared to strategies that focus on the performance of individual assets, asset allocation involves carefully calibrating the ratio that different asset categories take in your portfolio, considering the specific characteristics of the overall portfolio and your personal investor profile.
How does asset allocation reduce risk?
There are different asset classes, such as cash, stocks, bonds, real estate, mutual funds, cash alternatives, and other investment categories. Now, each of these is always correlated to the others differently.
For example, bonds have been observed to fall when the stock market is on the rise. However, real estate may perform better than expected whenever stocks fall.
The share of an investor’s total portfolio that is allotted to each asset class is determined by a certain asset allocation model that reflects the preferences, objectives, and risk appetite of the individual. Diversification reduces the volatility of a portfolio, and therefore offers a shield to guard against the deterioration of an investor’s investment.
Why is it so important?
Asset allocation is one of the first strategic decisions to make when building a strong investment portfolio, and is sometimes actually considered more important than selecting individual securities. It is therefore very important to understand and consider at the early (and ongoing) stages of portfolio management.
In particular, these are the two factors to consider when designing a portfolio:
- What asset classes are to be used? (Or which asset categories are to be left out)
- What should be the normal long-term weight of each asset class?
Moreover, your asset allocation strategy can also actually change as you age or revise your financial objectives. For example, you may want to scale back on more volatile equities as you age, but then increase investment in more stable bonds and fixed-income assets. Cash and cash equivalents have the lowest returns, and so you might not need them until retirement.
Asset allocation strategies
Conservative allocations would generally favor low-risk, lower-yield portfolios. These become more common as you get older or as investment timelines shorten. An example of a conservative asset allocation would be placing 70-80% of your portfolio in bonds, 15-20% in stocks, and the rest in cash or cash equivalents.
On the other hand, a more aggressive and higher-risk allocation would be favored by younger investors with long-term goals that may stretch decades down the line. This type of allocation might have 70% of a portfolio invested in equities, 20-25% in fixed income assets, and the remainder in cash.
Here are two simple and commonly-used approaches in asset allocation:
Age-based asset allocation
There are other common shortcuts, such as the recommendation that the percentage of equities in your portfolio equal 100 less your present age. This means that at 30 years old, setting aside 70% of your portfolio might be a good place to start calibrating your asset allocation strategy.
However, some financial planners are now also recommending that this “rule” be closer to 120 since Americans are living longer and healthier lives.
Asset allocation through mutual funds
Life-cycle (or target-date) funds provide investors with allocation structures that attempt to take into account their age, investment goals and risk tolerance. These funds seek to responsibly maximize return on investment for a large group of investors by standardizing strategies applied to all.
However, this takes away decision-making from individual investors, potentially failing to consider individual needs and profiles.
Finding your ideal asset allocation
Proper diversification is more than just spreading out your investments across different types of assets, and it takes time and effort to learn how to properly allocate the asset categories in your portfolio (either by consulting a professional or resources like this article).
There is no magic asset allocation strategy that can be applied to all investors, and the key to an effective allocation is evaluating what works best according to the three factors of age, risk appetite, and time horizon.
