Asset allocation refers to expanding your investments among a combination of equities, fixed-income and cash equivalents. Asset allocation is the hard execution of an investment strategy that tries to balance risk against reward by adjusting the percentage of all asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame.
The center is on the characteristic of the complete portfolio. Such a strategy contrast with an approach that focuses on individual assets.
The purpose of asset allocation is to maximize returns and maximize risk. Whereas there are no assurances that any specific mixture of investments will be more profitable or less risky than any other, a solid diversification strategy helps improve a portfolio of investments.
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.
1. Goals factors
Goals factors are individual goals to achieve a given level of return or saving for a specific reason or desire. Therefore, different goals affect how a person invest and risk.
2. Risk tolerance
Risk tolerance refers to how much an individual is eager and able to lose a given quantity of the original investment in expectation of getting a higher return in the future.
3. Time horizon
Time horizon factor depends on the period an investors is going to invest. Most of the time, it depends on the objective of the investment. Also, different time horizons need different risk tolerance.
Strategies for Asset Allocation
In asset allocation, there is no fixed rule on how an investor may invest and all financial advisors follow a diverse approach. The subsequent are the top two strategies used to influence investment choices.
Age-based Asset Allocation
In age-based asset allocation, the investment choice is based on the age of investors. Thus, most financial advisors recommend 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. The higher the life expectancy, the greater the portion. That’s why the base value might change to 110, or 120. For cash and money market investments, most advisors advice that the time horizon should be less than a year.
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 because of standardizations issues. In fact, every investor has unique differences across the three factors.
Examples of Other Strategies
Constant-Weight Asset Allocation
The constant-weight asset allocation strategy is based on the buy-and-hold policy. That is, if a stock loses value, investors purchase more of it. However, if it rises in price, they sell a larger proportion. The objective is to ensure the proportions never deviates by more than 5% of the original mix.
Tactical Asset Allocation
Tactical asset allocation is a strategy in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for perceived gains. Whereas an original asset mix is formulated much like strategic and dynamic portfolio, tactical strategies are often traded more actively and are free to move completely in and out of their core asset classes.
Insured Asset Allocation
For investors prone to risk, the protected asset allocation is the ideal strategy to implement. It includes setting a base asset value from which the portfolio should not fall from. If it falls, the investor takes the necessary action to prevent the risk. Otherwise, as far as they can get a value a little greater than the base asset value, they can comfortably buy, hold, or even sell.
Dynamic Asset Allocation
Dynamic asset allocation is similar to strategic asset allocation in that portfolios are built by allocating to an asset mix that seeks to provide the optimal balance between predictable risk and return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies largely retain exposure to their original asset classes; however, unlike strategic strategies, dynamic asset allocation portfolios will adjust their postures over time relative to changes in the economic environment.
Core-satellite asset allocation
Core-satellite allocation strategies usually contain a ‘core’ strategic element making up the most important portion of the portfolio, while applying a dynamic or tactical ‘satellite’ strategy that makes up a smaller part of the portfolio. Thus, core-satellite allocation strategies are a hybrid of the strategic and dynamic/tactical allocation strategies.
An asset class is a group of economic resources sharing similar characteristics, such as riskiness and return. There are many types of assets that may or may not be included in an allocation strategy.
Other alternative assets that may be considered include:
Commodities: metals, agriculture, energy, environmental.
Commercial or residential real estate
Collectibles such as art, coins, or stamps
Insurance products (annuity, life settlements, catastrophe bonds, personal life insurance products, etc.)
Derivatives such as long-short or market neutral strategies, options, collateralized debt, and futures
Whereas the SEC cannot recommend any specific investment product, you should know that a vast array of investment products exists – including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, life cycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities.
For several financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let’s take a closer look at the characteristics of the three major asset classes.
Stocks have generally had the highest risk and highest returns among the three major asset categories. As an asset category, stocks are a portfolio’s “heavy hitter,” offering the highest potential for growth. Stocks hit home runs, but also strike out. The volatility of stocks makes them a very risky investment in the short term. Big company stocks as a group, for instance, have lost money on average about one out of every three years. And sometimes the losses have been quite dramatic. But investors that have been willing to ride out the volatile returns of stocks over long periods of time generally have been rewarded with strong positive returns.
Bonds are usually less volatile than stocks but offer more diffident returns. As a result, an investor approaching a financial goal might raise his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor in spite of their lower potential for growth. You should keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.
Cash and cash equivalents – such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds – are the safest investments, but offer the lowest return of the three major asset categories. The risks of losing money on an investment in this asset category are usually very low. The federal government guarantees various investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do happen, but rarely. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.
Stocks, bonds, and cash are the most common asset classes. These are the asset classes you would likely select from when investing in a retirement savings program or a college savings plan.
Problems with asset allocation
There are many reasons why asset allocation fails to work.
- Investor manners are inherently biased. Although investor chooses an asset allocation, execution is a challenge.
- Investors approve to asset allocation, but after some good returns they choose that they really wanted more risk.
- Investors agree to asset allocation, but after several bad returns they decide that they really wanted less risk.
- Investors’ risk tolerance is not identifiable ahead of time.
- Security selection in asset classes will not necessarily produce a risk profile equal to the asset class.
- The long-run behavior of asset classes does not assurance their shorter-term behavior.
Investors looking to make an investment for a long period of time tend to emphasis their portfolios on stocks. One object for this is that common stock tends to outperform most other financial tools over a long enough timeframe. Investors who are looking to maximize returns over a shorter period, on the other hand, often diversify their portfolios by including investments other than stocks.
It is this principle that helped to guide the development of the concept of asset allocation. Asset allocation refers to an investment technique which objects to balance risk and make diversification in a portfolio by dividing assets through many major classes (stocks, bonds, real estate, cash, etc.). Because every asset class in the portfolio experiences different levels of risk and return, all tends to perform differently over a longer distance of time. While one type of asset may be increasing in value, another may be decreasing.
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