Asset allocation is based on a theory that investors can achieve higher total returns in their portfolio by splitting investments by asset classes, rather than individual investments within each asset class. Asset allocation looks at the different types of asset classes in your portfolio.
Asset Allocation Strategies
Asset allocation strategies, also known as schemes, are created prior to purchasing any investments. They are individual investment strategies that require an investor to determine how much money should be invested broadly across asset classes and also approximately for how long.
All schemes are based on one hundred percent of any investment amount. A few examples of asset allocation schemes are:
- Conservative/Short Term: 90% Cash and 10% bonds
- Balanced: 50% stocks and 50% bonds
- Aggressive/Long Term: 90% stocks and 10% bonds
Once an investor has chosen an asset allocation scheme, the investor will generally stick with that allocation for many years. The goal of asset allocation is to avoid making emotional short-term decisions based on current market events, by applying a preset model that avoids speculation.
Asset allocation schemes can be found in:
- Workplace retirement plans
- Individual Retirement Accounts (IRAs)
- 529 Plans, also known as College Savings Plans
- Financial Advisory firms
- Banks & Trust companies
Studies have shown that as much as ninety percent of a portfolio’s return comes directly from asset allocation. This means individual stock and security selection accounted for only ten percent of a portfolio’s return. Furthermore, researchers have found that asset allocation is far more successful at reducing risk.
Asset Allocation Alternatives
Most investors will be familiar with asset allocation schemes that use a fixed or flexible percentage weighting to distribute money, in order to match a specific portfolio. Asset allocation alternatives are used to provide investors with an opportunity to select a strategy without having to focus on percentages.
Asset classes are defined using broad characteristics, such as:
- Conservative = low return/low risk: Invests mostly in bonds and short-term securities
- Moderate = average return/average risk: Invests in U.S. stocks, bonds, and foreign securities
- Aggressive = high return/high risk: Invests in mostly stocks, both U.S. and foreign, with very little bond and short-term securities exposure.
Often, investors will see asset allocation alternatives with smaller investment firms and small business workplace retirement plans.
Portfolio characteristics are determined by the asset classes that are used to make up an investor’s portfolio. The following characteristics are used to describe each asset class:
- Stocks – Stocks are generally seed as a high risk, high return investment. They can return the most over time, but will fluctuate the most along the way. Some stocks are less risky than others, such as dividend stocks, and tend to do well in a growing economy and poorly in a weak one.
- Bonds – bonds are a debt instrument that pays regular interest income and tend to be relatively stable. Bonds are usually much safer than stocks, though the performance of the bond depends a lot on the quality of the issuer: government, corporation, or other type of bond.
- Real Estate – real estate investment trusts (REITs) and real estate mutual funds can help to diversify an investment portfolio. REITs typically own and operate real estate properties such as residential units, and commercial space. Real estate mutual funds can provide diversified exposure to real estate with a relatively small amount of capital. Real estate tends to appreciate slowly over time while throwing off cash known as cash flow.
- Cash – Cash and cash equivalents such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds are the safest investments, but offer the lowest return of the three major asset categories. However, it’s extremely important in a downturn because it can float you through an emergency and may be invested in assets that have declined in value.
- Gold – is a popular investment that often does well when the economy gets into trouble or when other assets are doing poorly. Many investors use gold as a hedge or a store of value, especially when they think inflation may pick up due to the government monetary policy.
- Alternatives – Includes private equity funds, obscure precious metals, farmland, art and whatever else investors think might not be correlated to the broader markets. Non-correlation is often key to what is categorized as an alternative asset.
Portfolios that are created using an asset allocation approach will align asset class characteristics with portfolio objectives.
- Preserving capital
- Generating current income
- Growing capital
- Reducing taxes
- Managing risks
These factors play an important role in determining the right asset allocation for an investor’s money, using very general characteristics.
When it comes to investing, risk and reward are inextricably entwined. You’ve probably heard the phrase “no pain, no gain” – those words come close to summing up the relationship between risk and reward.
Don’t let anyone tell you otherwise. All investments involve some degree of risk. If you intend to purchase securities – such as stocks, bonds, or mutual funds – it’s important that you understand before you invest that you could lose some or all of your money.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset classes with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.
Individuals who consider investing should plan for a variety of issues that could affect their financial situation personally. When deciding to invest, individuals should consider:
- Income – securing a well-paying job that will allow for a potential for higher returns with higher risks on investments, also higher income over time.
- Time horizon – How long will you be investing for? Retirement, a new home, car, vacation, etc.
- Risk tolerance – What do I want from my investment portfolio? Would I feel comfortable if I lost my entire investment? Perhaps half of my investment?
- Marital status and Family planning – Life events, such as weddings, children, and life planning may impact an investor’s ability to save.
- Investment experience – Someone who is new to investing may not feel comfortable buying stocks and other high-risk investments given limited experience over a more sophisticated investor.
- Economic outlook – Depending on where the economy is, there may be uncertainty or volatility that is outside of any one person’s control, which could increase the risk to an investor’s portfolio and plan.
Investment Allocation Characteristics
Investors tend to use one of two ways to allocate their investment assets: traditional asset allocation and tactical asset allocation. Let’s compare the characteristics of both:
Traditional Asset Allocation
Characteristics that help to define an individual investor who may be interested in traditional asset allocation:
- Hands-off approach: With this approach, you purchase investments in a certain mix and only rebalance them (buy some and sell others) when the allocation diverges from that mix.
- You want to buy and hold: You’ll purchase investments and keep them over the long term. This means you seldom have to move money around or incur the associated transaction fees.
- You have a long time horizon: The longer you have until you need the money in your portfolio, the more appealing a strategic asset allocation is since there is still plenty of time for the market to recover from potential downturns.
- You have limited investing experience: This strategy requires research but doesn’t require deep insights into market trends. You may want to choose this approach if you don’t have the experience needed to act on ongoing market events.
Tactical Asset Allocation
Characteristics that help to define an individual investor who may be interested in a hands-on tactical asset allocation:
- You want greater control: If you don’t have trust in the market to steer your investments in the right direction, this asset allocation strategy may be a better option.
- You’re willing to trade often: The opposite of buy-and-hold strategy is a trading approach where you don’t simply stick to your original investment choices over a period of years. Instead, you monitor them on an ongoing basis and act on investment opportunities as they arise. This may result in moving around money frequently, which can incur higher transaction fees.
- You have a short- to medium-term time horizon: A tactical approach may be more suited for money in a regular investment account that you’re looking to grow in the short term, rather than for a defined long-term goal.
- You have more expertise: If you have a lot of insight into the market and know how to prudently act on changes, this option may appeal to you. But there are no guarantees you will get better results than with a traditional asset allocation.
The primary goal for asset allocation is to preserve capital by avoiding negative economic developments, while taking advantage of positive swings for financial gain or profit. In other words, an investor could reduce risk by reducing correlation between asset classes.
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses.
Historically, the returns of the three major asset categories of Stocks, Bonds, and Cash have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.
Investors who invest in more than one asset category will reduce the risk of financial loss and experience far less volatility within the portfolio’s overall investment returns. If one asset category’s investment return falls, the investor will be in a position to hedge losses in that asset category with better investment returns in another asset category.
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