Asset allocation is a prudent, time-tested way to limit investment risk by dividing your investment portfolio among multiple asset classes. The three primary asset classes are cash, stocks, and bonds. Your asset allocation determines which of these assets you include in your portfolio and in what proportion. This is an individual process. Your asset allocation will depend on several factors, such as your risk profile and your time horizon for your investments.
Typical Assets in a Portfolio
Before you begin allocating assets, you need to understand what you’re allocating. A number of asset sub-classes exist within the three primary asset classes.
- Treasury Bills: This is a popular short-term investment with a maturity period of up to one year. T-Bills are backed by the US government.
- Fixed-Income Securities: These include government or corporate bonds. These securities will pay you a pre-determined interest amount, either at maturity along with the principal or at periodic intervals.
- Large-cap Stocks: Shares of companies with a market capitalization over $10 billion. These are generally considered to be among the safer stocks.
- Mid-cap Stocks: Shares of companies with a market capitalization of $2 billion to $10 billion. These are considered safer than small-cap stocks but riskier than large caps.
- Small-cap Stocks: Shares of listed companies with a market capitalization below $2 billion. These are usually considered riskier than large and mid-caps.
- International and Emerging Market Securities: Securities issued by foreign corporations listed on an international exchange are called international securities. You can expect higher risks and higher rewards, especially from companies in developing countries.
- Real Estate Investment Trusts: REITs pool funds from multiple investors to buy, operate or finance income-producing properties.
Large-cap stocks are generally considered to be low-risk, with risk levels increasing as company size decreases. While this is a useful general rule, there are exceptions. A heavily hyped large company may have an artificially inflated value. A large company in a stagnant or declining market niche may be a risky investment.
Time Horizon in Asset Allocation
Depending on your age, your family circumstances, and your financial goals, you can determine the estimated time period for which you would like to stay invested in a particular asset.
Younger people usually have a longer time horizon. They are more inclined to invest in relatively riskier and more volatile assets (such as equities). They can patiently wait out the periods of extreme market fluctuations and slowdowns, and earn superior long-term returns.
On the other hand, an investor who needs money for an approaching retirement or someone who is saving money for their children’s college education might have a shorter time horizon. They have less time to recover from a potential downturn. That means they should allocate more funds towards less volatile and more liquid assets in their investment portfolio.
Risk Profiles in Asset Allocation
Asset allocation will also depend on your individual willingness and ability to lose a part or all of your investment. Investors with a strong and stable running income or a very substantial net worth may have a larger risk appetite. They can afford to lose a small part of their portfolio value in their pursuit of exceptional returns.
New investors and small investors will usually want to maintain a balanced asset portfolio with relatively low risk. Your risk profile may go up as you become more comfortable with investing.
Here are some typical asset allocation guidelines for different risk profiles.
Very Conservative Profile
If your risk profile is very conservative, your will want your asset allocation to favor money market and fixed-income securities. These entail minimal risk. The primary objective is to preserve the principal capital at all costs. You won’t get dramatic returns, but your capital will be protected.
Consider putting half of that equity allocation into large, low risk companies and dividing the other half among medium-sized companies and established international firms. You may wish to choose funds focused on those areas, especially if you have limited funds to invest.
Conservative Risk Profile
If you’re a conservative investor you still want to protect capital. You may also be willing to embrace a bit of risk in search of better gains. You’ll still want to lean heavily toward cash and equivalents and fixed-income investments, but you may also want to beef up your stock allocation. You’ll be adding to the funds you have committed to stocks, but still sticking with conservative stock investments.
If you’re in the conservative bracket you will want to keep your fixed-income investments in government and high-rated corporate bonds. Your stock allocation will probably be dominated by large, stable companies and dividend-bearing stocks. You may want to look to well-diversified equity funds or index funds for your stock allocation. You could also consider adding small allocations for small company, international, or emerging market funds.
Balanced Risk Profile
If you are neither a highly conservative nor a highly aggressive investor, you may have a balanced risk profile. You may want to select stocks of companies that pay high dividends, have minimal debt and high cash reserves, and have a long track record of performance in the stock markets.
Your might half of your stock portfolio between large cap and mid cap stocks and distribute the rest among the riskier but more growth-oriented classes. You might allocate smaller amounts to some more adventurous stocks, targeting smaller companies, growth-oriented companies, or emerging market funds. To minimize risk and to ensure superior returns, it is best to have a time horizon of at least five years for a balanced investment portfolio.
With an aggressive risk profile you can afford to invest aggressively in the hope of higher returns. The largest asset allocation in your portfolio should be in stocks. Within that category, you can carefully select large cap, mid-cap and small cap stocks as well as mutual funds.
Within these categories, an investor might look at a diversified portfolio of higher-risk bonds with relatively high yields. The stock portfolio might retain allocations for conservative large cap and mid cap stocks but could devote more than half its allocation to toward riskier growth-oriented stocks. You might look for more exposure to individual stocks rather than funds.
Very Aggressive Profile
If you have a long time horizon and a strong desire to crush the market, you may fit the “very aggressive” risk profile. A very aggressive risk profile means that you’re willing to take risks that other investors won’t, but they still need to be calculated risks. It’s about being aggressive, not stupid. You’ll be willing to tread where many other investors won’t go. You’ll still want to balance your allocations, hedge some bets, diversify your portfolio, and manage your risks.
Within that allocation you may wish to emphasize newer growth-oriented companies, some international assets, and other stocks that offer higher growth potential but entail higher risk. You will still want to diversify those aggressive holdings and not put too many eggs in one basket. The more risk you take on, the more important diversification becomes.
Why Does Asset Allocation Matter?
Asset allocation is the broader form of diversification. When one asset class has a strong market demand, the other asset classes may not be delivering good returns. Investing across multiple asset classes can give you a level of protection against market fluctuations.
Your investment portfolio will be more liquid at all times, and you will generally have a
smoother ride in terms of your long-term portfolio returns. Asset allocation is a proven risk mitigation strategy. A disciplined asset allocation approach will prevent you from ending up putting all eggs in one basket and incurring excessive risks. Warren Buffett famously spoke about the two golden rules of investing:
Rule no. 1: Never lose money.
Rule no. 2: Never forget rule number one.
Making Changes to Your Asset Allocation
The future is unforeseeable. At some point, your investment priorities might change. There may be a change in your risk tolerance or your time horizon. In many cases, as people inch closer towards their retirement, they may want to increase the allocation of cash and bonds while reducing the stocks allocation in their portfolio, especially in uncertain economic conditions.
Unless your financial goals or your financial situation have changed, it may not be a smart idea to frequently change your asset allocation in the short-term. Seasoned investors usually do not make significant changes to their asset allocation just on the basis of the temporary market performance of certain asset classes.
For instance, just because the stock market is currently hot and going through a bullish phase, it does not mean you should increase the allocation of stocks in your portfolio at the expense of other asset classes. it may be a good time to “rebalance” your investment portfolio, as experienced investors typically do when one asset class outperforms.
Portfolio rebalancing is a way to restore the original asset allocation of your investment mix. With the passage of time, rebalancing becomes essential because some of your assets may no longer be aligned with your investment goals. Markets are unpredictable, and you will have little control when some of your assets grow much faster than others.
Portfolio rebalancing can ensure that your investments are not overly biased towards a
particular asset class, and you will be able to restore your portfolio to a manageable level of risk tolerance.
There are three ways to rebalance your portfolio:
- Add new investments in asset classes that have become under-represented in your portfolio.
- Sell some of the over-emphasized asset classes and utilize those funds to increase exposure to some under-weighted assets.
- If you make periodic contributions to your investment portfolio, you can make adjustments to increase the contributions to under-represented asset classes until the balance is restored.
It may seem strange to reduce your exposure to asset classes that are performing well. Over time, though this strategy is effective. Taking gains once an asset class has risen can protect you from a subsequent down cycle and add to holdings in assets that remain relatively inexpensive.
The Final Word
Asset allocation is a foundational approach to investing that will let you minimize your risk and maximize your returns. Stick to your core investment philosophy and risk tolerance when determining your asset allocation. Do not make drastic changes to your portfolio just because one asset class is doing exceptionally well at the moment, and another class is going through a phase of stagnation.
It can be tempting to concentrate your portfolio towards the hot asset of the day, but investors who have ‘seen it all’ know that nothing is permanent in the markets. Keep an eye on your long-term investment goals, time frames, and risk tolerance levels while choosing and maintaining your asset allocation strategy for the best outcomes.
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