Asset allocation is a strategy for increasing investment return while helping to manage investment risk. Divide and conquer is often the best way to win your investment battle.
You allocate by assigning percentages of your overall portfolio to different categories of investments known as asset classes.
Each asset class differs from the others in some critical ways, including how the value of the underlying investments is determined and how they put your money to work.
There are several reasons why asset allocation is a crucial principle of sound investing:
- No single asset class produces the strongest return year in and year out.
- Different asset classes tend to produce their strongest returns at different times and under different conditions.
- An asset class with a strong return in one year may have a weak return in the next, or the reverse.
As a result, if you’re invested in several asset classes at the same time, you can benefit from each class’s strong years without being as vulnerable in their weak ones—provided, of course, that you don’t move all your money into the current strong performer and sell off the weak one.
Following asset allocation formula
To make your allocation decisions easier, financial professionals have devised some standard formulas for dividing up your portfolio based on factors including your age, your investment goals, your liquidity needs, and the amount of risk you’re willing to take. These models are flexible, though, and you can adapt them to your own needs.
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For example, you may decide on a classic allocation model—say 60% in stocks, 30% in bonds, and 10% in cash—and stick with it. Or you may decide to be more aggressive, increasing your stock holdings to 80% early in your financial life, and then become more conservative by reducing them to 40% after you retire.
Thinking in percentage terms as you add money to your accounts may seem complicated, but it’s really not. If you’re using the moderate 60%- 30%-10% approach, for example, each time you have money to invest—say $1,000—you could put $600 into a stock mutual fund, $300 into a bond fund, and $100 into a money market fund toward the purchase of your next CD or T-bill.
While your overall portfolio may never be allocated as precisely as a hypothetical model, perfection isn’t what you’re after. But by adding money to all three investment categories, you’ve made it easier to maintain the allocation you want.
Picking up an asset
Deciding on the percentages of your investment assets to allocate to stocks and stock ETFs and mutual funds, bonds and bond ETFs and mutual funds, and cash and cash equivalents isn’t an easy task. There’s no single asset allocation that’s right for everyone. And the one that’s appropriate when you’re 25 probably won’t be suitable when you’re 50 or 75. That’s because the element of unpredictability in investing, especially investing in stocks and stock funds, isn’t such a threat when you’ve got a long time to reach your goals. But if you’re counting on your investment assets to meet an important near-term goal, you’ll probably want to reduce the risk of losing your principal.
In addition to your age, you also have to consider what your goals are, what they are likely to cost, the size of your investment portfolio, and your risk tolerance in selecting an allocation. Investment experience also plays a role.
While many investors stick to stock, bonds, and cash, others investigate adding small percentages of real estate, equity options, commodity funds, and direct investments to the mix. One reason is to include noncorrelated investments, or those whose prices are not influenced by the same factors that drive changes in stock and bond prices.
A cyclical pattern
Investment markets and the economy as a whole tend to move in recurring cycles that affect how different asset classes perform. For example, the prices of existing bonds tend to drop when market interest rates rise and increase when rates fall. Stocks, on the other hand, tend to gain value when rates fall and may retreat when rates rise.
While you can’t pinpoint when rates will change or the timing and intensity of any of the other factors—such as corporate earnings, unemployment rates, or political uncertainty—that affect investment performance, you can count on asset allocation to smooth, though not eliminate, the impact on your portfolio value. In contrast, if you owned only stocks when stock markets were falling, there would be nothing to cushion the blow. One word of caution, though: Asset allocation doesn’t guarantee a profit or insulate you from losses in a broad market downturn.
It’s just as important to allocate the investments in your retirement funds as it is to direct the money you’re investing on your own. That may mean putting a substantial part of your 401(k) or IRA account, for example, into stocks and some into fixed-income investments, though probably little or nothing in cash. It also means looking at the bigger picture of your retirement and nonretirement investments together. For example, if you’re putting most of your 401(k) money in stock mutual funds, you may want to balance that by putting a larger share of your nonretirement money into fixed-income investments.
Or, if you know you’re eligible for a specific, fixed-income pension when you retire, you may want to invest more heavily in stocks on your own. Sorting out all the details and figuring out the best overall allocation is one of the ways working with your financial adviser may make a real difference to your bottom line.
Asset Allocation – Definition, Strategies, and Examples by Inna Rosputnia
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