Asset Allocation: Best Guide to Manage Your Wealth
Asset allocation is an investment strategy to diversify a portfolio's assets in hopes of balancing risk and reward according to an individual's goals, risk tolerance, and time horizon.
Meanwhile the three main asset classes are equities, bonds, and cash and equivalents, all of which have different levels of risk and return to perform differently over time.
For example, stocks are historically with the highest rates of return while bonds as well as cash and cash-like assets are with lesser returns, which is more suitable to conservative investors.
While stocks, bonds and cash are the three broad assets, beginner investors can consider investing a bigger share on ETFs which can diversify their investment portfolios and are often cheaper than buying blue chip stocks.Below please find more information on asset allocation.
What is Asset Allocation?
Asset allocation is an investment strategy to diversify an individual’s investment portfolios according to his/ her investment goals, risk tolerance, and time horizon.
Generally speaking, the three main asset classes are stocks, bonds, and cash, all of which have different levels of risks and returns over time.
- Stocks, also known as equities, are generally considered riskier or aggressive assets, but they suppose to have the highest returns;
- Bonds are fixed incomes which are typically considered safer or conservative assets, but their returns may be lesser than those of stocks;
- Cash and equivalents include savings accounts, certificates of deposit (CDs), money market mutual funds, and beyond, which investors can enjoy potential upside even if the risk is very minimal.
Anything outside the aforesaid categories, such as real estate, commodities, and art, is referred to as alternative assets instead.
What is Strategic Asset Allocation?
Strategic Asset Allocation (SAA) means that the investor sets target allocations for various asset classes based on his/her investment objectives, risk tolerance, and time horizon, during which he/she will rebalance the original portfolios periodically with a hope of making different returns from the various assets.
The target allocations vary depending on the individual’s investment goals and the degree of risk that he/she can endure, given the volatility of the value of the investment.
Let’s make an example! Ken is an ambitious investor who has a SSA of 60% stocks, 30% bonds and 10% cash with a portfolio worth of $500,000, all of which need to be rebalanced annually. Then, his first-year asset allocation should be like this:
Original Asset Allocation
| Asset Class | Weight of SAA | Portfolio |
|---|---|---|
| Stocks | 60% | $300,000 |
| Bonds | 30% | $150,000 |
| Cash | 10% | $50,000 |
| Total | $500,000 |
One year later, the stocks generated a return of 15% while the bonds generated a return of 5%, but the return of cash remained unchanged. The portfolio value is now $567,500, which means the overall return on the portfolio over the past year was 13.5% to make Ken’s unbalanced portfolio look like this now:
After 1 year
| Asset Class | Weight of SAA | Portfolio |
|---|---|---|
| Stocks | 60.8% | $345,000 |
| Bonds | 30.4% | $172,500 |
| Cash | 8.8% | $50,000 |
| Total | $567,500 |
To follow the SAA strategy, Jeff rebalanced the portfolio to 50% stocks, 40% bonds and 10% cash based on the increased portfolio value, as shown below:
After rebalancing the portfolio
| Asset Class | Weight of SAA | Portfolio |
|---|---|---|
| Stocks | 50% | $283,750 |
| Bonds | 40% | $227,000 |
| Cash | 10% | $56,750 |
| Total: | $567,500 |
Therefore, at the end of the year, the SAA strategy would involve selling $61,250 worth of stocks and putting $54,500 in bonds and $6,750 in cash.
Once you have decided upon an allocation, you stick with that allocation for a while so that it helps you work steadily toward a financial goal over a long span of time and to avoid making emotional short-term decisions based on current market events.
While strategic asset allocation takes a more passive approach to investing, tactical asset allocation, in contrast, involves a more active approach, but all in all, the best method for you depends on your investing goals and styles.
Factors to consider when planning for your Asset Allocation
Investment goals
Different investment goals help you to make more returns and navigate risks because the objective is a reflection of an investor’s aspiration to achieve a given level of return or saving for a particular reason or desire, which also affects the person’s overall investment strategy on the asset allocation.
Risk tolerance
Simply put, it refers to how much an individual is willing to lose a given amount of their original investment in hopes of getting a higher return in the future.
Risk-averse investors will take a more conversative approach like buying more bonds and keeping more cash while aggressive investors’ portfolio distribution will focus more on stocks because they are willing or able to accept higher volatility.
Time horizon
It depends on the duration that an investor is going to invest, for long term or for short term, which also entails different risk tolerance.
Frequently Asked Questions (FAQ)
What is Asset Allocation?
- Asset allocation refers to an investment strategy to diversify an individual’s investment portfolios according to different factors including investment goals, risk tolerance, and time horizon.
Why is asset allocation important?
- Historically, stocks and bonds have an inverse relationship that when one goes up, the other will generally down, hence striking a good balance between the two can position your portfolio to retain value and grow
Should I adjust my asset allocation strategy according to the market situation?
- No, it isn't advisable since you can't predict the ever-changing market trends so it's better to follow a planned asset allocation strategy to make rational decisions instead of blindly following the trends or even following your heart.