Asset allocation is a crucial strategy used to ensure that a financial portfolio performs efficiently and produces maximum returns according to the financial needs of an investor.
What is Asset Allocation?
An investment portfolio usually consists of various asset classes, including equities or stocks, bonds, and cash or cash derivatives, to name a few. When creating a financial portfolio, an investor or financial advisor decides on the amount of each asset class to invest in and allocates the assets accordingly. For example, an advisor allocates 60% equities or stocks, 30% bonds and 10% cash to a portfolio.
Why is Asset Allocation Important?
Asset allocation is vital to ensuring that an investment portfolio is profitable and receives a reasonable rate of return.
Determines the profitability of an investment portfolio
The percentages of assets allocated could determine the profitability of a portfolio. Load a portfolio with too many equities and not enough bonds, and the risk of losses could be much higher in volatile markets, or have too high a bond concentration, and one could risk the possibility of low returns or even losing capital due to returns lower than inflation.
Determines the risk profile of a portfolio
The percentages of various asset classes will determine the risk tolerance of an investor. Generally, a higher concentration of equities in a portfolio means higher risk and potentially higher returns. Bonds have a lower risk but also potentially lower returns. Each investor is comfortable with a specific risk profile or level of risk.
An investor with a more aggressive risk tolerance would have a higher concentration of equities or stocks and a low bond and cash concentration. This means more risk of losses but also potentially higher returns.
A more conservative investor would potentially have equal equities and bonds to preserve capital.
It is a critical element of diversification
Asset class diversification is one of the best strategies to protect a portfolio against the risk of losses and market volatility. Different assets have different characteristics and risk levels. A portfolio is diversified against risk by choosing assets with different characteristics and assets that react differently to market volatility.
Asset class allocation is but one strategy of diversification; others include diversifying across various regions and various sectors.
For example, asset classes like equities and bonds can come from different regions (US, Europe, Asia, etc.) and sectors (Pharmaceuticals, Oil and energy, Financials, Tech, etc.) This adds an extra layer of diversification to protect a portfolio against market risk—basically, diversification within diversification.
Can the Asset Allocation of an Investment Portfolio Change?
Asset allocation can and will change over time due to various circumstances.
As the investor or investment ages
As investors age and get closer to retirement, they may wish to preserve capital for retirement and take on less risk. This means reducing the equities portion and increasing the lower-risk bond portion. Also, as an investment reaches the end of its investment term, it is vital to preserve the capital with less risky assets.
As the investor’s risk profile changes
Generally, younger investors tend to be more aggressive with investing and have a higher risk tolerance. As an investor nears the years closer to retirement, the emphasis is to preserve the capital they have saved over the years. This means changing their risk profile or tolerance and reducing the risk of losses of the investment by changing the asset class weighting.
Market fluctuation can cause overweighting
Over time, asset classes perform differently and offer different returns. If one asset class performs better over time, it will hold a heavier portion of the portfolio than initially intended, thus increasing risk. Rebalancing is required. A financial advisor would rebalance a portfolio (selling and buying assets) to return to the original asset weighting and risk level that the investor is comfortable with.
Leave Asset Allocation to the Experts
If asset allocation seems daunting, don’t stress; let the qualified experts do it. Your financial advisor will allocate assets according to your risk profile. Also, many funds are already diversified into various asset classes, regions, and sectors for investors, which takes the stress out of investing. Qualified fund managers administer these funds and make investing decisions on the investor’s behalf.
Please note, the above is for educational purposes only and does not constitute advice. You should always contact your financial advisor for a personal consultation.
* No liability can be accepted for any actions taken or refrained from being taken, as a result of reading the above.
