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.
In this article, we will explain what asset allocation is, why it is important, and how to choose the best asset allocation for your goals, risk tolerance, and time horizon. We will also show you some examples of basic asset allocation models and how to adjust them over time.
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.
Three primary investment asset classes are equities, cash and cash equivalents, and fixed income.
Equities: 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 cash 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.
Further Read: Understanding Asset Classes in Stock Market
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There are different 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.
Here are three asset allocation scenarios for different investment objectives:
Conservative Asset Allocation:
Moderate Asset Allocation:
Aggressive Asset Allocation:
These asset allocation scenarios serve as general guidelines and can be adjusted based on an individual's financial goals, risk tolerance, and time horizon. It's crucial to regularly review and rebalance your portfolio to ensure it aligns with your objectives and adapts to changing market conditions. Consulting with a financial advisor can provide personalized guidance in constructing an asset allocation strategy tailored to your specific needs.
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.
Terms that you need to know
ETF: It is a type of investment fund that is designed to track the performance of a specific index, commodity, bond, or basket of assets.
Mutual Fund: It is a professionally managed investment vehicle that pools money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities.
Bonds: Bonds are issued by governments or corporations to raise money. The investor is paid a fixed interest by the bond issuer.
CD: A certificate of deposit is a savings account that holds a fixed amount of money over some time while the owner earns interest from the issuing bank.
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.
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