Five Things to know about Asset Allocation
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We all have heard this saying “Do not put all your eggs in one basket”. This is one of the primary philosophies of personal finance. It means that when you’re investing you are advised not to put all your money in one asset class. This is where asset allocation comes into the picture. Asset allocation refers to the diversification of your portfolio across different broad asset classes like stocks, bonds, and cash and cash equivalent.
Key Takeaways
- Asset Allocation is a type of investment strategy to balance risk and rewards by allocating various asset classes based on your risk tolerance, goals, and time horizon.
- The risk and return tradeoff are the primary aims of asset allocation.
- Time horizon is your ally, it allows investors to take advantage of compounding and the time value of money.
What is Asset Allocation? Why is it Important?
As explained above asset allocation is allocating your money into different asset classes like stocks bonds, and cash or cash-like assets. The aim is to align your asset allocation with your risk tolerance and investment time horizon. Broadly, there are three primary asset classes equity, fixed income, and cash and cash equivalents have different levels of risks and returns, and each will trade and behave differently over time. There are also alternative investments that are not your conventional investment categories. It includes private equity, venture capital, commodities, hedge funds,
There is no one rule or way to allocate your assets it can be different for every individual based on their preferences. Investors can use different asset allocation strategies for different objectives. Asset allocation ensures that the risk of the portfolio is spread across different asset classes. It helps in minimizing volatility and maximize returns.
Different types of Financial Assets
KID5 Things to know about Asset Allocation
What is Your Goal?
Asset allocation can be primarily based on your investment objective, risk appetite and the years left to achieve the financial goals you have set it. It should ideally not change as per your expectation of returns from various assets. Although, based on the actual performance of the assets you might have to rebalance your portfolio to stick to your original asset allocation goal to mean your long-term goals.
The key to generating risk-adjusted returns in one’s portfolio is the right asset allocation. The returns generated in your investment portfolio are a function of allocation across different asset classes like equity, debt, real estate, gold, etc.
Risk Tolerance
Risk tolerance refers to how much is an individual willing and able to lose a given amount from their original investment for an opportunity of earning a greater rate of return. The risk tolerance of an individual is a personal decision and needs proper evaluation.
The risk tolerance of an individual influences asset allocation by deciding the proportion of aggressive and conservative investments you can have in your portfolio. It means the percentage of stocks, bonds, or cash you hold.
The crashes of 1929, 1981, and 1987, and the recent declines following the global financial crisis between 2007 to 2009 as well as the covid-19 fall are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. (Source: Investing.com). Having your assets allocated to prepare yourself for these downfalls can reduce the unwanted risk of sticking to one asset class.
Time Horizon. It is your Best-friend
Having a long-time horizon can allow investors to take advantage of compounding and the time value of money. As it is said, “Time in the market is more important than timing”. The time horizon depends on the duration the investor plans to invest. Different time horizons offer different risk tolerance.
If an individual opts for aggressive, higher-risk allocations, his or her account value may fall more in the short term. But with a big-time horizon, you can wait for the market to recover and grow, which historically it has after every downturn, even if it hasn’t been done instantly. (Source: Forbes)
Historically, after each recession since 1920, it has taken the stock market an average of 3.1 years to reach pre-recession highs, accounting for inflation and dividends. Even taking into account bad years, the S&P 500 has seen average annual returns of about 10% over the last century. The problem here is that you are never sure when a recession or dip is going to arrive. If your investing timeline shrinks, you might want to make your asset allocation more conservative (bonds or cash).
Diversification
As mentioned above of various asset classes, there are various subcategories in each asset class with different risk profiles one can choose from. Investors can diversify within different assets and subcategories as per their goals.
The performance of broad asset classes has no tandem over each other. The performance of various asset classes is primarily based on factors that are unique to them. The economic micro or macro and other factors can have a positive impact on one asset class and be different for others. Hence, if your investments are distributed across various assets the likelihood of your assets maintaining their value is high.
Diversifying across assets could help manage the inherited risk of specific assets. If returns in one asset class fall, the balance may be maintained by the better-performing asset in your portfolio. In the asset allocation process, an individual is not relying or banking on any one of the assets to perform instead they are spreading their risk-reward ratio across the asset classes.
Don’t try to juggle your Investments in Short-Term
The temptation to move your investments from one asset to another based on their short-term momentum and performance could be avoided. If you have already set your goals and allocated your assets based on your medium and long-term goals, the short-term momentum and gains could be avoided. Moving funds and juggling between your assets and investments carry a cost and doing so could be futile over the long term.
If the economy is performing well and so are the markets it is tempting to that certain asset classes like stocks might perform well and that belief might encourage you to hold more stocks than you originally planned, however, the market won’t be performing in the same trend forever. It could be a mistake; you cannot time the market, or any asset class and you won’t know when the correction is coming. Hence following a planned strategy of asset allocation could be a better option. If you let market conditions influence your allocation strategy, then you’re not following a strategy at all.
The Bottom Line
The future is unpredictable and uncertain, and it might throw some surprises at you when it comes to financial investments. So, to keep the uncertainty and minimize the risk a robust financial plan and allocation of assets across various asset classes is important. Asset allocation is not a one-time event, it's a life-long process of rebalancing, fine-tuning, and evolving as per your situation.
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