What is Asset Allocation?
Asset allocation refers to an investment
strategy in which individuals divide their investment portfolios between
different diverse assets classes to minimize investment risks. The assets classes fall
into three broad categories: equities, fixed-income,
and cash and
equivalents. Anything outside these three categories (i.e. real
estate, commodities, art) is often referred to as alternative assets. These
asset allocations change over time depending on a variety of different factors,
including the investor’s time horizon, personal goals and risk tolerance.
Asset Allocation of Financial Portfolio is
equally important to that of Health diet. As a healthy diet for any individual is
a perfect blend of carbohydrates, vitamin, protein, fat, fibre and minerals, the financial portfolio also requires a blend of different asset categories.
Asset allocation helps investors reduce risk
through diversification.
Historically, the returns of stocks, bonds, and cash haven’t moved in unison.
Market conditions that lead to one asset class outperforming during a given
timeframe might cause another to underperform. The result is less volatility
for investors on a portfolio level since these movements offset each other.
In addition to diversification, asset
allocation is essential to ensure that you reach your financial goals. An
investor that isn’t taking on enough risk might not generate high enough
returns to reach their goal, while an investor that’s taking on excessive risk
may not have enough money when they need to access it. Selecting the right
asset allocation helps avoid these issues by ensuring that a portfolio is
ideally positioned to reach a goal.
Factors Affecting Asset Allocation Decision
When making investment decisions, the
investors’ portfolio distribution is influenced by factors like personal goals,
level of risk tolerance, and investment
horizon.
Personal Goals / Goal Factors
Goals factors are individual aspirations to
achieve a given level of return or saving for a reason or desire. Therefore,
different goals affect how a person invest and risk.
Risk tolerance
Risk tolerance refers to how much an individual
is willing and able to lose a given amount of the original investment in
anticipation of getting a higher return in the future. For example, risk-averse
investors withhold their portfolio in favour of more secure assets. On the
contrary, more aggressive investors risk most of their investments in
anticipation of higher returns. Know your risk tolerance score.
Time horizon
Time horizon factor depends on the duration an
investor is going to invest. Most of the time, it depends on the goal of the
investment. Similarly, different time horizons entail different risk tolerance.
For example, a long-time investment strategy may prompt an investor to invest
in a more volatile or higher risk portfolio since the dynamics of the economy
are uncertain and may change in favour of the investor. However, investors with
short-term goals may not invest in riskier portfolios.
How Asset Allocation Works
Financial advisors usually advise that to
reduce the level of volatility of portfolios, investors must diversify their
investment into various asset classes. Such basic reasoning is what makes asset
allocation popular in portfolio management because different asset classes will
always provide different returns. Thus, investors will still receive a shield
to guard against the deterioration of their investments.
Strategies for Asset Allocation
In asset allocation, there is no fixed rule on
how an investor may invest and each financial advisor follows a different
approach. The following are the top two strategies used to influence investment
decisions.
Age-based Asset Allocation
An age-based asset allocation, the investment
decision is based on the age of the investors. Therefore, most financial
advisors advise investors to make the stock investment decision based on a
deduction of their age from a base value of a 100. The figure depends on the
life expectancy of the investor.
Life-cycle funds Asset Allocation
In life-cycle funds allocation or
targeted-date, investors maximize their returns on
investment (ROI) based on the factors like their investment
goals, their risk tolerance, and their age. This kind of portfolio structure is
complex due to standardizations issues. In fact, every investor has unique
differences across the three factors.
Conclusion
Asset allocation is one of the most important
decisions that an investor will make for their financial future. By choosing
the right mix of stocks, bonds, cash, and other asset classes, you can ensure
that you are set up to reach your financial goals.
