What is Asset Allocation?
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame.
Furthermore, Asset Allocation is based upon the premise that the different asset classes have varying cycles of performance (non-correlation of assets), and that by investing in multiple classes, the overall investment returns will be more stable and less susceptible to adverse movements in any one class.
All investments involve some sort of risk. An individualized asset allocation strategy seeks to mitigate the risks of any one asset class through diversification and balance.
What do you mean Non-correlation of assets?
Many financial experts argue that asset allocation is an important factor in determining returns for an investment portfolio. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions.
A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Asset diversification has been described as “the only free lunch you will find in the investment game”.
How does this work for me?
When a portfolio is allocated properly the assets will reflect his/her desired goals, priorities, investment preferences and his tolerance for risk. Asset allocation is an individualized strategy, so there really is no perfect mix of assets. Each individual’s strategy is built on the careful consideration of the key elements of their financial profile.
- Investment Objectives: What the investor hopes to achieve using his/her investment dollars. It may be to improve current lifestyle; achieve capital growth; fund a specific goal; or ultimately retire.
- Risk Tolerance: Reflects the investor’s comfort level with market fluctuations that can result in losses. (See Risk Tolerance in the Glossary)
- Investment Preference: An investor may prefer one asset class over another based on a certain bias or interest towards the characteristics of that class.
- Time Horizon: The length of time an investor is willing to commit to achieving his objectives.
- Taxation: Asset classes will have varying tax consequences. Some asset classes are structured to minimize the expense of taxes or have tax benefits.
What is an asset class?
An asset class is a group of economic resources sharing similar characteristics, such as riskiness and return. There are many types of assets that may or may not be included in an asset allocation strategy.
There are “traditional” asset classes which include stocks, bonds, and cash or money market funds. And there are many types of subsets of stock funds, bond funds and cash equivalents. Just about anything the mind can conceive. Allocation among these three provides a starting point.
There are also “alternative asset classes” which include but are not limited to Commodities, Real Estate or REITs (Real Estate Investment Trusts), Collectibles (Art, Coins, and Stamps), Insurance products, Currencies and many more.
Is there only one way to allocate your investments?
Actually there several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification. Primarily we use strategic and tactical Asset Allocation.
- Strategic Asset Allocation — the primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.
- Tactical Asset Allocation — method in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains.
Once I have decided on my Asset Allocation Strategy, Am I stuck with it?
A sound asset allocation strategy includes periodic reviews. The only certainty when it comes to the financial markets is change. In fact we often refer to the one constant in the universe as . . . “change”. The financial markets change and your financial situation will change. Through market gains and losses, a portfolio can become unbalanced and it may be important to make adjustments to your allocation. As you move through your stages in life your needs, preferences, priorities and risk tolerance change and so to must your asset allocation strategy.