A Complete Guide to Asset Allocation

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.

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.

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.
Adjust allocation over time to match changing circumstances.

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.

Also Read: Why Investing Is Important: Don’t Let Your Savings Sit Idle

Types of assets

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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Different types of asset allocation strategies

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.

Three Asset Allocation Scenarios

Here are three asset allocation scenarios for different investment objectives:

Conservative Asset Allocation:

Objective: Capital Preservation and Income
Asset Mix:
60-70%: Fixed-Income Securities (e.g., Bonds)
20-30%: Equities (e.g., Stocks)
5-10%: Cash and Cash Equivalents (e.g., Money Market Funds)
Rationale: This conservative approach is suitable for investors seeking to protect their capital and generate a steady stream of income. It prioritizes the stability of fixed-income investments while maintaining a small equity exposure for potential growth.

Moderate Asset Allocation:

Objective: Balanced Growth and Income
Asset Mix:
40-50%: Equities (e.g., Stocks)
40-50%: Fixed-Income Securities (e.g., Bonds)
5-10%: Cash or Cash Equivalents
Rationale: Investors with a moderate risk tolerance aim for a balance between capital appreciation and income. This allocation diversifies between equities and fixed-income assets to manage risk and provide growth potential.

Aggressive Asset Allocation:

Objective: Long-Term Capital Growth
Asset Mix:
70-80%: Equities, including domestic and international (e.g., Stocks)
15-20%: Fixed-Income or Alternative Investments
5-10%: Minimal Cash Holdings
Rationale: Aggressive investors are willing to take on higher risk to pursue substantial long-term returns. They focus predominantly on equities, seeking capital appreciation, and may diversify with some fixed-income or alternative assets for risk mitigation.

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.

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.

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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