When you’re looking for the right investment strategy, asset allocation is one you might consider. It’s often a strategy used for balancing risk and reward in a portfolio. If you’re considering investing, you should learn more about asset allocation below.
What Is Asset Allocation?
According to Investopedia.com, “Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon.”
Asset allocation isn’t the same for each person. There isn’t a magic formula either. It’s customized to fit the goals, risk, and needs of the individual portfolio.
Asset allocation is an important investment strategy to consider. It might just be the right option for you. The selection of individual securities comes secondary with this type of strategy to how the assets are allocated into bonds, stocks, and cash.
Different Asset Classes to Consider
When you plan to use asset allocation, you will have several different asset classes to consider including:
- Stocks – One of the riskier options since you can lose your entire investment, stocks offer the best possible return. You will find stocks split into small-cap, mid-cap, and large-cap.
- Cash – The least risky of the assets, but also the one with the smallest return, you can hold cash in a money market account or in a certificate of deposit.
- Bonds – You can use this fixed-income investment as a lower-risk option. U.S. Treasury bonds are the safes as they are 100% guaranteed by the federal government. They offer a slightly higher return than cash. You can also invest in state and municipal bonds or even junk bonds.
- Real Estate – Another investment type you might consider is real estate. You can invest in a real estate investment trust (REIT) or pooled real estate fund.
- Currencies – You can also invest in currencies outside the dollar. As the dollar becomes weaker, another currency might become stronger making it a good investment.
- Derivatives – A higher risk option, with higher returns, you can invest in derivatives if you’re not afraid of the risk.
- Commodities – Some commodities can be very risky, while others come with a lower risk. This category includes things, such as oil, gold, silver, and food.
All of these asset class types can be considered when using asset allocation.
Common Factors Impacting an Asset Allocation Decision
When choosing to use asset allocation as an investment strategy, there are several factors that might sway your decisions. Some of the most common factors include:
- Goals – Your actual investment aspirations will be a big factor in how you make asset allocation decisions. Whether you’re trying to invest to make money, for retirement or to protect what you have, it will make a difference in your decisions.
- Risk Tolerance – The amount of risk you’re willing to take on will also impact your decisions with asset allocation. Some investments carry more risk and work best for those willing to take the risk. Others fit more with risk-averse investors.
- Time Horizon – How long you plan to invest is also a factor and it’s known as the time horizon. If you’re investing for retirement, you might use a long-term investment strategy compared to someone trying to create wealth faster.
Asset allocation comes with several decisions you will need to make. These three factors will be the driving force behind those decisions.
Asset Allocation vs. Diversification
Asset allocation is certainly an important part of creating a diverse portfolio. However, it’s not the same as diversification. It’s possible to allocate all your money across many assets without having proper diversification.
Maybe you have stocks in your portfolio and they are all securities in large-cap companies. You don’t have any diversification, but you have allocated your assets.
When you diversify your portfolio, you will have different risk and return levels throughout your portfolio. Allocating your assets can help with this, but you want to also use diversification properly.
An Example of How Asset Allocation Works
Let’s assume you’re an investor with $20,000 to infest. You split this money into three different investment vehicles, which are fixed-income, cash, and equities.
Since you’re investing $10,000 into equities, you decide to buy $7,000 in index funds that will track large-cap companies and another $3,000 in index funds that will track small-cap companies.
Then, you decide to put another 30% of your money into fixed-income investments. These are split between municipal bonds and U.S. treasury bonds evenly. The final 20% or $4,000, you decide to hold as cash in a money market account.
With this type of asset allocation, you will have protection against a large loss due to the bond investments and the cash. However, if the stock market takes off, you will also do well due to the investments in large-cap and small-cap funds.
Why is Proper Asset Allocation Important?
When you allocate your assets based on your customized investment strategy, it’s considered proper allocation. You want to make sure you’re properly hedged against losses on your higher-risk investments.
Having a balanced portfolio with equities, cash instruments, fixed income, and maybe a few other investment types can be a good strategy. Asset allocation works best with the right diversification.
It may vary from one age of an investor to another, too. If you’re rather young and investing for retirement, you have many more years to invest compared to someone in their 50s or 60s preparing to retire soon. The longer your life expectancy, the more risk you can often take with your investments.
Within the category of asset allocation, there are several investment strategies to consider. Working with a professional is a great way to make sure you get the right strategy for you. It’s important to make sure you’re comfortable with your investments. Using a proper asset allocation strategy can help.