An Introduction to Asset Allocation

Portfolio asset allocation is an investment strategy that aims to balance between risk and reward by assigning a percentage each asset makes up in an investment portfolio. This is usually done according to the investors’ risk tolerance, goals and investment time frame.

The consensus among many financial experts is that asset allocation is an important factor in determining fair returns for an investment portfolio. In general terms, riskier investments, such as equities, are expected to provide the best returns over the long term even though they may be volatile in the short run.

Why is Asset Allocation important? 

The fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated; including diversification in a portfolio will allow an investor to reduce his overall risk in terms of the variability of returns for a given level of expected return.

Broadly speaking, there are the three main types of asset classes – equities, fixed-income, and cash & equivalents, all of which have different levels of risk and return characteristics. Finding the optimal asset basket is often the hardest thing for an investor to do because there is no secret formula or magic number that exists. Each investor is unique and only he can determine the right mix for him.

Deciding what’s Right for You 

For simplicity sake, you can utilise a simple rule of thumb for portfolio allocation. Subtract your age from 100 and that’s the percentage of your portfolio that you should keep in stocks. For example, if you’re 30, you should keep 70% of your portfolio in stocks. If you’re 70, you should keep 30% of your portfolio in stocks.

The rationale behind this is that when you are younger, you are generally able to take on more risk. Since stock markets move in cycles but generally increases over the long run, it is an advantage to young investors who are able to hold their stocks for a longer time horizon.

If you are looking for the right asset allocation, you can check out useful website such as this one. It incorporates a few key points like: how risk tolerant you are & what actions to undertake when market sell-downs happen.

Constant Review of Your Portfolio 

After you are done constructing your portfolio with your desired asset allocation, it is important to conduct periodic portfolio reviews (the norm is on an annual basis). The value of the various assets in your portfolio will vary over with time, affecting the weightage of each asset class within it.

Take for example – a rising stock market over the year as you hold 60% in stocks and 25% in bonds. The value of the equity portion will have increased significantly, perhaps to around 80% weightage of your entire portfolio.

In order to reset your portfolio back to its original state (60% in stocks and 25% in bonds), you need to rebalance your portfolio. Rebalancing is the process of selling portions of your portfolio that have increased significantly, and using those funds to purchase the other asset class which is bonds in this case. This process is also important if your investment strategy or tolerance for risk has changed.

Conclusion

Asset allocation is a fundamental investing principle, because it helps investors maximise profits while minimising risk. Customising your own portfolio based on your own risk tolerance and circumstances will enable you to reach your long-term investment goals at a comfortable pace and risk level.

 

 

Royalty-free photo from Getty Images. Used with appreciation.

 

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