What Is Asset Allocation?
Asset allocation is an investment strategy which involves diversifying a portfolio among different asset classes, such as stocks, bonds, and cash equivalents. The goal of asset allocation is to decide how money should be distributed among investments in order to achieve maximum growth with acceptable risk levels. It can involve stock picking within asset classes or across asset classes. Different asset allocations are appropriate for different investors depending on such factors as their age, financial goals, and risk tolerance. Understanding asset allocation and applying it to your investments may help you reach your goals and provide better financial security in the long run.
How Does Asset Allocation Work?
The practice of distributing the money in your investing portfolio across stocks, bonds, and cash is known as asset allocation. The idea is to match your asset allocation to your risk tolerance and time horizon. In general, the three major asset classifications are:
Stocks. Stocks, also known as equities, have historically provided the best rates of return. Stocks are often seen as riskier or more aggressive investments.
Bonds. Historically, fixed income has delivered lower rates of return than stocks. Bonds are often seen as more secure or conservative investments.
Cash and Cash Equivalents. While cash isn’t typically thought of as an investment, cash equivalents such as savings accounts, money market accounts, certificates of deposit (CDs), cash management accounts, treasury bills, and money market mutual funds are all ways for investors to enjoy potential upside while assuming very little risk.
You’ve undoubtedly previously considered your investing portfolio in terms of stocks and bonds. However, cash and cash-like assets play a vital role in asset allocation. These liquid assets have the lowest rate of return of any asset class, but they also have the lowest risk, making them the most conservative (and steady) investment asset.
You may achieve your desired asset allocation by purchasing individual stocks or bonds. New investors, on the other hand, should adhere to exchange traded funds (ETFs) and index funds.
There are several funds to pick from, each of which holds a diverse range of equities and bonds based on a certain investment strategy, such as replicating the performance of the S&P 500, or asset category, such as short-term municipal bonds or long-term corporate bonds.
Delving Deeper Into Asset Allocation
Asset allocation is the process of allocating money among various asset classes, such as stocks, bonds, and cash. You should allocate your funds between the two depending on your risk tolerance and the length of time you have until you need the money (time horizon).
Asset Allocation And Time Horizon
Your time horizon is a metaphor for when you’ll need the money you’re investing. You have a limited time horizon if you invest in January for a trip in June. You have a lengthy time horizon if it is 2023 and you expect to retire in 2050.
With short time spans, a sharp market downturn might devastate your assets and prevent you from recouping losses. As a result, experts suggest that your asset allocation for a short time horizon consist mostly of cash assets, such as savings or money market accounts, CDs, or even certain high-quality bonds. You don’t make much money, but the risks are modest, and you won’t lose the money you need to go to Aruba.
You may have many years or decades until you need your money if you have a longer time horizon. This gives you the ability to take on much greater risk. You might allocate more money to equities or equity funds, which have greater upside potential. If your original investment rises significantly, you’ll need less of your own money to achieve your investing objectives.
Your account value may decline more in the short term if you make aggressive, higher-risk investments. However, since you have a long-time horizon, you can wait for the market to rebound and expand, which it has historically done after every slump, even if not immediately.
After each recession since 1920, the stock market has taken an average of 3.1 years to return to pre-crisis highs, after accounting for inflation and dividends. Even when terrible years are factored in, the S&P 500 has averaged yearly returns of around 10% over the previous century. The problem is that you never know when a recession or a slump will occur. As your investment time frame shortens, you may wish to shift your asset allocation to be more cautious (bonds or cash).
For objectives with fewer well-defined deadlines or more flexibility—say, you want to travel to Australia sometime in the next five years but don’t have a specific date in mind—you may take on more risk if you’re prepared to wait until your money recovers or if you’re willing to accept a loss.
Asset Allocation And Risk Tolerance
One’s risk tolerance may be defined as the percentage of an investment one is ready to lose in exchange for the possibility of a higher rate of return. You alone know how much of a chance you’re willing to take.
Those with a poor risk tolerance are those who, although knowing that market fluctuations are inevitable, still find them difficult to handle. Your risk tolerance is high if you are able to ride out short-term volatility in the market with the knowledge that you are investing for the long haul.
The asset allocation decision is affected by one’s risk tolerance since it determines the mix of aggressive and cautious investments. Simply put, this refers to the proportion of your portfolio that is comprised of stocks, bonds, and cash.
Losses will occur regardless of risk tolerance, even if it’s only due to inflation; however, the magnitude of those losses will vary depending on the volatility of the asset allocation selected.
Your investment horizon may cause you to keep a more cautious portfolio, even if you’re comfortable taking on a lot of risk. For example, if you’re just a few years away from retirement, you may shift to a portfolio with a greater emphasis on bonds and fixed income.
Portfolio Rebalancing and Asset Allocation
The process of allocating assets is not a one-time affair. As you move closer to achieving your objectives, the asset allocation that you seek may shift over time. But even before that happens, it’s possible that you’ll see something called “portfolio drift,” which is the movement of your allocations away from where you originally planned for them to be. This might occur if there is a rapid increase in the value of stocks or if bond interest rates (and the prices connected with them) drop.
It is recommended by most financial advisors that you check in on your investment portfolio at least once or twice every year to see how it is doing. Your asset allocation may need to be rebalanced, which may require you to sell certain assets and purchase others in order to bring it back into line. This will depend on the performance of your holdings.
Asset allocation is an important asset in any investor’s portfolio. It helps manage risk, diversify investments, and ultimately optimize returns. The process of asset allocation considers both your investment goals and risk tolerance and makes use of asset classes such as stocks, bonds, cash and more to reduce the volatility of portfolios. By allocating investments in a variety of asset classes provides a better balance between risk and reward to achieve higher long-term returns over time. Asset allocation is an essential tool to help preserve capital, manage risks effectively and generate higher potential returns for investors who take the time to formulate it appropriately.
Ultimately, asset allocation is an important step in the investment process and should not be overlooked. Careful consideration, research and planning must go into developing an appropriate asset allocation strategy that works best with your individual risk tolerance and long-term goals. By understanding the fundamentals of asset allocation, rebalancing your portfolio regularly, and keeping an eye on market trends, you can develop a sound investment strategy. But no matter what your strategy looks like or the markets you pick to invest in, diversification helps reduce your exposure to risk while providing an array of potential benefits.
Therefore, it is essential to create and maintain a diverse portfolio. If you need guidance on how to build out an effective asset allocation plan or want help making investment decisions based on market analysis, Nancy Hite is at the ready to help you get the most out of your investments. So, don’t hesitate in contacting us for more information about what we can do for you when it comes to asset allocation and managing your investments.
Let Us Help You Allocate The Assets In Your Investment Portfolio!
Content provided by Paradox Media.
This information is not intended to substitute for specific individualized tax, legal, or investment planning advice. Neither Royal Alliance Associates nor its representatives or employees provide legal or tax advice. If legal or tax advice or other expert assistance is required, the service of a currently practicing professional should be sought.