What is “Asset Allocation”?
Asset allocation is the process by which an investor allocates their portfolio across different asset classes in accordance with the investor’s level of risk tolerance or capacity, investment goals and time horizon. Assume that an investor wants to invest US$100,000. Then he or she needs to determine or specify the proportion (or percentage) of these funds which will be invested in different asset classes – usually stocks, bonds, and cash (these three major asset classes have different levels of risk and return). For example, if an investor’s investment portfolio has 60% of assets allocated to stocks, 30% to bonds and the remaining 10% to cash, then this is her or his asset allocation – which is sometimes termed as “60/30/10”. Given the impact on investment returns, asset allocation is one of the most important decisions for an investor to make.
Key Learning Points
- Investment goals, risk tolerance or capacity, and time horizon are three key factors that investors take into account while determining asset allocation;
- Asset allocation helps optimize investment portfolio returns, minimize risks and taxes, and enables investors to meet both short and long term financial needs;
- Diversification can protect an investor against significant losses, as returns on stocks, bonds, and cash typically do not move up and down at the same time; and
- Strategic Asset Allocation is a strategy in which an investor first attempts to establish fixed asset allocation and adhere to such an allocation for long periods.
Asset Allocation – The Fundamentals
While deciding on asset allocation, three factors are very important for investors in determining the same: their investment goals, how much risk can they tolerate, and the time horizon.
Asset allocation is important, as it helps to optimize investment portfolio returns, minimize risks, which is inherent in all investments, enable investors to attain a balance between investments to meet both short term and long term needs, and minimize taxes.
Diversification can protect an investor against significant losses and could result in a less volatile ride with reference to the overall investment returns on a portfolio. This is because returns on stocks, bonds, and cash, typically do not move up and down at the same time. For example, returns on equity investments fall, the losses in this asset class could be counterbalanced with better investment returns in some other asset class, for example, bonds.
In asset allocation, it is advisable to diversify not only into stocks, bonds and cash but also attempt to diversify within these asset classes. For example, in stocks, one can hold individual stocks or invest in investment vehicles such as mutual funds or exchange traded funds (ETFs) which already tend to be diversified. In bonds, one could have a holding across maturities and sectors, or also invest in bond funds. With reference to cash, one could have a savings account in a bank and purchase a certificate of deposit (CD) that is less liquid but has a higher interest rate.
Strategic Asset Allocation – An Investment Strategy
In strategic asset allocation, you have to decide how much money, for example, US$ 100,000, do you want to invest or allocate across varied categories of investments or asset classes such as stocks, bonds and cash over the long term. For example, an investor might choose to have or establish an allocation in which 60% are stocks, 30% are bonds and 10% is cash, this is known as the target allocation. An investor who is more risk tolerant will usually tend to invest more of his or her money in stocks (for example, 85% in stocks and 15% in bonds). The investor, on a periodic basis, will then rebalance the portfolio if it has moved away from the target asset allocation.
One also needs to decide what sub-categories of investments will you choose among competing alternatives – for example, choosing between domestic (for example, the US) stocks and international stocks, or small-cap or mid-cap stocks.
Given below is a workout of varied (8) examples of strategic allocation approach: conservative, moderate with income, moderate, balanced, growth with income, growth, aggressive growth and all stocks. Allocation of money, across asset classes, under each approach, is based on an investor’s tolerance for risk.