What Is Asset Allocation?
Asset allocation is the strategy of splitting your investment portfolio among diverse asset classes, like stocks, bonds, and cash. These asset classes possess varying characteristics, including risk levels, return potentials, volatility, and their correlations with other assets.
KEY TAKEAWAYS
- Asset allocation is the strategy of dividing investments into different asset classes.
- It's important for risk management, enhancing returns, and goal achievement.
- Choose allocation based on goals, age, and risk tolerance.
- Asset classes include equities, cash, and fixed income.
- Strategies include strategic, dynamic, and tactical allocation.
- Asset allocation can be adjusted over time to match changing circumstances.
Terms that you need to know
Bonds: Bonds are issued by governments or corporations to raise money. The investor is paid a fixed interest by the bond issuer.
Volatility: Change in an asset's price over a specified period.
ETF: ETF is a type of investment fund that is designed to track the performance of a specific index, commodity, bond, or basket of assets.
Mutual Funds: It is an investment vehicle that pools money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities.
Common Stock: Common stock is essentially a share in a company's ownership. Their owners usually receive voting rights and dividend payments.
Preferred Stock: Stock holders are preferred for dividend payments but they usually don't have voting rights.
Types of Assets
Three primary investment asset classes are equities, cash and cash equivalents, and fixed income.
Equities/Stocks: Equity investments provide an investor with a share of ownership in a business. These investments encompass common stock, preferred stock, mutual funds, and exchange-traded funds (ETFs). Among these equity investments are growth stocks, which may offer dividend income or not pay dividends.
Cash and equivalents: Cash and equivalents include cash, savings accounts, money market accounts, and bank CDs.
Fixed income: Fixed-income investments are like lending money to a company, government, or person, and in return, you receive regular fixed payments. These can be things like corporate bonds, municipal bonds, Treasury bonds, and even various types of loans, such as mortgages, bridge loans, or personal loans, which promise a fixed income payment.
Why Is Asset Allocation Important?
Asset allocation is important for several reasons:
Risk Management: Diversifying your investments across different asset classes can effectively lower the risk in your overall portfolio because your portfolio's performance doesn't rely on a single asset class.
Enhanced Returns: You are expected to earn better risk-adjusted returns if you allocate assets per your financial goals and risk tolerance.
Achieve goals: Asset allocation strategies play a pivotal role in helping you achieve your financial goals by distributing your investments across various asset types, taking into account your risk tolerance.
Avoiding Concentration Risk: By spreading your investments across various assets, you avoid the risk of having too much money tied up in a single investment, which can reduce the negative impact of an underperforming asset.
Considerations for Asset Allocation
Whenever you are deciding where to invest your money, you have to keep these important factors in mind. These will help you make better decisions.
Goals and Objectives: Your goals always matter in your investment strategy. Your goals will basically decide how the next factors are going to affect you. You can be investing for a long-term financial goal or for a quick short-term profit. You can also be investing and saving up for an important event in your life like a marriage or sending your kid to college. So, your investment strategy and asset allocation should work towards your goals.
Time Horizon: Time horizon is basically the time after which you will need your money back. Now you can have a long-time horizon of 30 or 40 years if you are investing for retirement or a short-time horizon if you are investing for a quick profit. For long-term, goals you can invest in low-risk and low-reward assets but for short-term goals, you might have to invest in high-risk and high-reward assets.
Risk Tolerance: If you are investing for an important thing like your child's college education then you will have to be conservative with your asset allocation. You will try to stay away from high-risk investments. But if it is some personal short-term goal then you can take on more risk and potentially bigger profits to get to that goal faster.
Asset Allocation Strategies
There are key types of asset-allocation strategies:
Strategic asset allocation: This asset allocation strategy is also known as static asset allocation. Strategic or static asset allocation is based on target allocations for different asset classes. In strategic asset allocation, you should stick to the target asset allocation ranges irrespective of market conditions. However, periodic rebalancing is required to return the asset allocation to the target.
Dynamic asset allocation: In this asset allocation strategy, you change your asset allocation depending on market conditions. For example, in some dynamic asset allocation strategies, you will decrease your equity allocations and increase your debt allocations as equity valuations increase. When equity valuation decreases, you will do the reverse i.e. increase equity allocation and decrease debt allocations.
Tactical asset allocation: Tactical asset allocation is a variant of strategic asset allocation strategy wherein the investor can occasionally deviate from the core strategic or dynamic asset allocation to take advantage of market opportunities. Tactical asset allocation involves market timing and requires considerable investment expertise.
Rebalancing
Rebalancing is the act of changing your portfolio to match the asset allocation that you started with. This is actually needed because after some time some of your assets might have grown faster than the other assets present in your portfolio. Thus, you need to reallocate your money to match the asset allocation that you are comfortable with.
If there's an asset that has grown more than the rest of your portfolio, then you can either sell a part of that asset and invest that money into other assets or you can invest more money out of your pocket into the other asset to again balance out your portfolio.
Conclusion
Asset allocation is one of the most important aspects of investing. It can help you achieve your goals, manage your risk, and take advantage of market opportunities. By choosing the right mix of assets for your profile and adjusting it over time, you can optimize your portfolio performance and enjoy the benefits of investing.
