Any expert on investment will tell you that asset allocation is the most fundamental idea of investment. However, when it comes to the best asset allocation advice, opinions vary because it is almost impossible to predict a person’s asset allocation requirements beforehand. The process of asset allocation advise is a very dynamic process, it varies with the available time horizon and personal appetite for risk. The same person can be an aggressive investor in his early twenties and a very conservative one in his seventies and of course the available time horizon changes with time.
Asset allocation is mainly dependent on two basic things- risk tolerance and time horizon. Time horizon is the time period available to achieve a desired financial goal. A person in his early thirties who is investing for retirement has a long time horizon. If, however, he is saving for a summer vacation he only has a short time horizon. Risk tolerance is a person’s appetite for risk and varies for individuals. One person may be ready to risk some of his assets in exchange for a higher rate of return, while a second person may be more risk-averse.
Generally higher the risk of an investment, higher is the possibility for greater returns. Every investment carries a percentage of risk. The risk may be higher or lower depending on the type of the investment, but riskier investments also has the potential of creating greater returns. Investments with supposedly low risks carry inflation risk, the risk that the investment will not keep up with the inflation. The value of an asset can erode over time if the return on that asset is less than the rate of inflation.
The Three Asset Categories
Stocks, bonds and cash/cash equivalents are the three most important asset categories. There are also other types of asset categories such as real estate, commodities and precious metals. Each asset category has its own share of advantages and risks. Among the three important asset categories, stocks as a group promises the highest rate of return while also being the riskiest. Stocks are highly volatile and are not recommended as an investment for an immediate financial goal. However, in the long run, stocks have the highest rate of return with the historical average rate of return for stocks being 10 to 12 percent.
Bonds are comparatively less riskier than stocks and they also have modest rates of return. Cash and cash equivalents such as money market instruments and bank deposits have almost zero risk since these are guaranteed by the government. At the same time, returns are generally less than the rate of inflation and so they carry inflation risk.
Why is asset allocation important?
Finding the right mix of the three asset categories is important because asset allocation is an important factor determining the future performance of a person’s portfolio. There is no ‘perfect’ asset allocation mix. While a conservative investor may lean towards bonds and money market instruments, an aggressive investor will have a higher percentage of stocks in his portfolio.
After deciding on what percentage of stocks, bonds and money market instruments to own, decide on the type of stock, bond and money-market instruments. In order to lessen the impact of stock market volatility or economic downturn, it is important to spread the investment in different types of asset classes. This is called diversification. For example, a person investing seventy percent of his assets in stocks may decide to further diversify his portfolio by investing in different types of stocks, such as growth stocks, value stocks, small cap stocks and large cap stocks. A diversified portfolio is more shock-proof to market volatility.
Successful investors diversify their portfolios and they also re-balance their portfolios over time. A wise investor will re-balance his assets from shares to bonds and cash equivalents when his financial goal approaches. For example, a parent who is investing for the college education of his daughter will gradually move his assets from stocks to bonds when she is a teenager. He will then shift his portfolio primarily to money market instruments when she is within one year of starting college. This protects his assets against a sudden market meltdown while also maximizing the potential for growth.
The importance of asset allocation and diversification cannot be overemphasised. The best asset allocation advice is to diversify between asset categories and also within the asset categories. A properly diversified portfolio with the right asset allocation mix is the best bet against market fluctuations, inflation and economic downturns.
- U.S Securities and Exchange Commission website, https://www.sec.gov/investor/pubs/assetallocation.htm
- Investor.gov website, https://investor.gov/beginners-guide-to-asset-allocation-diversification-and-rebalancing/
- FINRA website, https://apps.finra.org/Investor_Information/Smart/401k/401101.asp
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