Asset allocation refers to an investment strategy which intends to balance reward and risk. It does so by distributing a portfolio’s assets as per the investor’s risk tolerance and goals. The three core asset groups – cash, equities, and fixed-income have varying levels of return and risk. Hence, each behaves differently over time.
What is Asset Allocation?
Asset allocation divides an investment portfolio across different asset groups like bonds, stocks, and money-market-securities. Asset allocation is an efficient and organized way to diversify.
Your options usually fall into three groups – cash, stocks, and bonds. Within these categories are sub-groups. Some of the alternates and sub-groups include:
- Small-Cap Stock – These signify smaller companies that have a market cap of not more than $2bn. Such type of equity tends to involve the maximum risk because of lower liquidity.
- Mid-Cap Stock – Medium-sized firms issue these shares with a market cap usually between $2-$10bn.
- Large-Cap Stock – Large firms issue these shares with a market cap generally over $10bn.
- Emerging Markets – This group signifies securities from the markets of emerging nations. Though investments in developing markets provide higher return potential, the risk is also higher. This is mainly because of lower liquidity, political instability, and national risk.
- International Securities – Foreign companies issue these assets which are then listed on the foreign exchange. Such securities enable diversification outside the home country. But, there’s also exposure to national risk – the possibility that a nation won’t honor its financial commitments.
- Money Market – These’re debt securities which are very liquid investments having maturities of not more than a year. Treasury bills comprise most of these kinds of securities.
- Fixed-Income Securities – This group includes debt securities which pay the holder a fixed interest amount at maturity or periodically. The holder also gets a return on principle at the time of maturity. These securities have lower instability as compared to equities. Plus, the risk is even lower due to the consistent income they offer. Remember, that although the issuer assures income payment, there’s a possibility of default. Government and corporate bonds make up most of these securities.
- Real-Estate Investment Trusts – REITs trade akin to equities. But here, the core asset is a part of a pool of properties or mortgages, instead of ownership of a business
Asset Allocation: Maximizing Return and Minimizing Risk
The primary objective of asset allocation is risk-minimization and return maximization. Yes, to reduce risk and increase return, you must be aware of the risk-return traits of the different asset groups.
Equities carry the highest risk, but their return potential is also the highest. In contrast, T-bills take the least risk as the government supports them. But then they give the lowest return.
This is what we call the risk-return trade-off. Note that high-risk options are more suitable for investors who have a high tolerance for risk. Plus, investors who have a more top time horizon to recuperate from losses may also choose high-risk options.
This’s due to the risk-return trade-off according to which potential return increases with a rise in risk. Varied assets carry various risks and market volatility. Hence, efficient asset allocation protects your portfolio from the fluctuations in a single group of securities.
So, while a portion of your portfolio may be more unstable securities, the other half holding other assets stays stable. Due to the insulation it provides, asset allocation is essential to minimize risk while maximizing returns.
Determining What Assets Are Good for You
Every asset group has a differing level of risk and returns. Hence, investors must consider their goals, capital availability, time horizon and risk tolerance to decide the asset composition. Investors are having a longer time horizon, and large capital may be comfortable with high-risk-high-return choices. In contrast, investors with smaller capital and short horizon may be satisfied with low-return-low-risk choices.
Many investment firms develop a set of model portfolios to make asset allocation more accessible for clients. These models contain different percentages of asset groups. Such portfolios meet a specific level of risk tolerance. The model portfolios, in general, range from very aggressive to conservative.
Such model portfolios usually apportion a large percent of the overall portfolio to low-risk securities. E.g., money-market and fixed-income securities. The prime goal of this portfolio is to insulate your portfolio’s principal value. Hence, these models are commonly known as “capital preservation portfolios.”
You may be conservative and choose to avoid the stock market entirely. But, a little exposure may help you offset inflation. You may invest the equity part in an index fund or high-grade blue-chip firms. This will meet your goal of not beating the market.
Moderately Conservative Portfolios
You prefer preserving a big part of their portfolio’s principal value, but can take the higher risk? Then somewhat conservative portfolio is perfect for you. “Current income” is a common strategy under this risk category. Through this approach, you may pick securities which do coupon payments or high dividends.
Moderately Aggressive Portfolios
The other name of these portfolios is “balanced portfolios.” This is because the asset composition is equally divided between equities and fixed-income securities. As a result, there’s a balance between income and growth. Moderately aggressive portfolios carry a higher risk than conservative portfolios. Hence, this strategy is ideal for investors having longer time-horizon and mid-level risk-tolerance.
These mainly comprise equities, and so their value fluctuates immensely. If you have this portfolio, then your prime goal is obtaining long-run capital growth. Hence, “capital growth” strategy is another name of aggressive portfolio strategy. To bring some diversification, investors having aggressive portfolios usually add few fixed-income securities.
Very Aggressive Portfolios
Such portfolios have equities in entirety. If you hold this portfolio, your prime aim is having aggressive capital growth over long-term. As these portfolios have high risk, its value varies immensely in the short-term.
Customize Your Allocations as Per Your Needs
Remember that the above description of model portfolios and their strategies provide just a basic guideline. You may customize the composition to meet your own needs. How you tailor the models may depend on what type of an investor you’re and your capital needs.
E.g., you like to do homework about the companies and give time to stock selection. In this case, you’re likely to divide the equity part of your portfolio among sub-groups of stocks. When you do so, you can get a specialized risk-return potential within one part of your portfolio.
Plus, the amount of money-market securities or cash and its equivalents in your portfolio will depend on how much safety and liquidity you want. If you need liquid investments, you may want to put a more prominent part of the portfolio in short-term fixed-income securities. Or for that matter money-market securities. Investors do not have liquidity concerns, and a high-risk tolerance will have a smaller part in these instruments.
Asset Allocation Strategies
While deciding your portfolio’s composition, remember the different allocation strategies and their objectives. Each offers a varied approach depending on investor’s goals, risk tolerance, and time horizon. The most common strategies are tactical, constant, strategic weighting and systemic allocation.
Why Should You Maintain Your Allocated Portfolio?
So, you’ve decided the portfolio allocation strategy. Now, it’s crucial to carry out periodic portfolio assessments because the asset values will change. It impacts the weighting of every asset group. This means your portfolio can grow over-time from having one asset group to another. E.g., you begin with a moderately-conservative-portfolio. Now, the equity part may increase in value during the year. This will suddenly give you a substantial equity portfolio. It makes the portfolio akin to a person using a balanced portfolio strategy, which involves higher risk!
To reset your portfolio to its initial state, you must rebalance the portfolio. Rebalancing involves selling parts of your portfolio which have significantly increased. Then using the same funds to buy extra units of assets whose value didn’t rise much. This process is also crucial if your risk tolerance or investment strategy is no different.
Developing a suitable asset composition is a dynamic process. It has a vital role to play in determining the overall risk and return on your portfolio. As such, the asset mix of your portfolio must represent your goals at any point in time. We outline different strategies to establish asset allocations and review their management approaches.
Types of Strategic Asset Allocation
This approach establishes and sticks to a “base policy mix.” It’s a proportional mix of assets depending on projected rates of return for every asset group. E.g., if the historical return from stocks is ten %p.a. And that of bonds is five %p.a. In this case, a combination of 50% stocks and 50% bonds would give a return of 7.5%p.a.
Constant-Weighting Asset Allocation
Strategic asset apportionment usually means a buy-and-hold strategy. This holds true even if a shift in asset values drifts from the original policy mix. Due to this, you can use a constant-weighting approach for asset allocation. Through this strategy, you continuously re-balance your portfolio. E.g., if the value of one asset declines, you’ll buy more of that asset. In contrast, if the value is increasing, you’ll sell it.
There’s no strict rule to time portfolio rebalancing under constant-weighting or strategic allocation. But, a general thumb rule is that you should rebalance the portfolio to its initial mix if any asset group shifts over 5% from its original value.
Tactical Asset Allocation
In the long-run, a strategic allocation approach might appear rigid. Hence, you may find it essential to engage in tactical, short-term deviations from the combination. This will help you capitalize on exceptional or unusual investment opportunities. Such flexibility brings a market timing element to the portfolio. Hence, you can participate in economic situations more favorable toward one asset group than for others.
Tactical asset allocation is a moderately active strategy. This is because the entire strategic asset composition is returned to after attaining desired profits. But, this approach demands discipline because you should first identify when short-term opportunities have completed their course. And then you must be able to rebalance the portfolio to the position of a long-term asset.
Dynamic Asset Allocation
This is also an active asset apportionment method. With this strategy, you may continuously adjust the asset mix as markets fall and rise. Through this approach, you sell assets which are declining and buy those which are increasing. Hence, this strategy is opposite of constant-weighting strategy. E.g., if the stock market is weak, you sell expecting further decreases. In contrast, if the market shows strength, you buy stocks expecting continual market gains.
Insured Asset Allocation
This strategy helps you create a base portfolio value. Under this, the portfolio mustn’t drop. As long as the portfolio attains a return over its base, you follow active management. You do this to increase the value of the portfolio to the maximum. However, if the portfolio must ever fall to the base value, then you put money in risk-free assets. This way, the base value is fixed. During this time, you’d check with your advisor on re-allocation of assets. Maybe even altering your strategy altogether.
Insured asset allocation might be ideal for investors who’re risk-averse. Investors who prefer a degree of active portfolio management but like the security of setting a fixed floor. E.g., an investor who wants to set a minimum living standard after retirement may find this strategy suitable.
Integrated Asset Allocation
With this strategy, you consider both the risk and economic expectations in setting an asset mix. Though all the above outlines of strategies consider expectations of future market returns. But, not every strategy considers investment risk tolerance. In contrast, integrated asset allocation covers elements of all strategies. It examines not only expectations but also your risk tolerance and real changes in markets. This is a broader strategy of asset allocation. Hence, it allows just either constant-weighting or dynamic allocation. Evidently, an investor wouldn’t prefer implementing two approaches that compete with each other.
Asset Allocation in Retirement
For retirees, the ideal strategy to allocate assets isn’t a one-size-fits-all method. Many variables are determining your proper cash/stock/bond allocation. This includes your risk tolerance, age, goals, etc. Below is an accessible guide to help you find the ideal allocation for your IRA, 401(k) and other accounts.
Step 1: Understand the Basic Principles of Asset Allocation
Asset-allocation means deciding the percentage of bonds, stocks and cash-based assets in your investment portfolio.
The basic idea behind this is that stocks provide the best potential for long-term growth. But, these can be very unstable during short periods. In contrast, bonds are excellent at preserving your capital. But, they have a limited potential for returns. Lastly, cash assets don’t have any risk, but they earn decidedly fewer returns too.
As you’ll see, asset-allocation is to find the right blend of risk and return potential.
Step 2: Use Your Age to Find Your Ideal Bond/Stock Mix
Note that we didn’t mention cash/stock/bond mix. Why? Because even during retirement we don’t encourage people to keep much cash. The cash with you shouldn’t exceed your near-future living costs. I think that every penny of yours must be earning something back. Plus, there’re bonds which are less risky than cash but pay more than many savings accounts. Short-term treasury is an example.
Keeping that in mind, we have a good thumb rule to predict your perfect asset allocation. Take your present age and minus it from 110. The result is the percentage of your assets which you must allocate to stocks and the remaining to fixed-income assets. E.g., you’re 70. This means 40% of your assets must be in equity and the remainder in fixed-income investments.
Step 3: Assess Your Risk Tolerance
Can you handle your portfolio reducing by 50%? Don’t be surprised. The stock market did this before. And it may do so again. Hence, as a rule, don’t put money in stocks if you’re uncomfortable with the volatility that surrounds it. But, the fixed-income aspect of your portfolio can offset this risk when the tides are rough.
Investing, of any type, involves risk. Plus, markets will move. The point is to design your portfolio in a manner to keep the fluctuations low. Only then can you achieve the growth and income you desire.
Hence, the next step is evaluating your risk tolerance. Use the age-based allocation from the 2nd step. And then adjust accordingly if you think your risk tolerance is lower or higher than other investors of your age-group. E.g., you have a relatively significant Social Security benefit plus a pension coming in. Thus, you might be willing to take some more risk with your investments. Why? Because much of your daily income needs are satisfied.
Step 4: Pick Your Investments
It’s critical to know that not every stock carries the same risk. E.g., a small-cap stock or emerging-market stock will be more unstable than a large-cap index fund. So, retirees must always pick low-volatility stocks.
Step 5: Do Your Homework
Our last point is that asset allocation during retirement isn’t something you do just once. Instead, it’s crucial to re-assess your allocation regularly all through your retirement. Especially when a significant life change happens.
For example, if you retire by 65, your nest egg must survive for some decades. Hence, though you might be getting income from your investment, still growth is a priority. In contrast, when you’re 80, growth is not much of a priority. During this time, income and capital preservation become the prime focus.
Besides, over time, your allocation can distort because of your investments’ performance. This is especially true if your stocks have performed well or very badly. Due to these reasons, it’s wise to re-assess your portfolio to bring changes every few years.
Asset allocation can either be an active process to multiple degrees or be passive. An investor can choose a specific asset allocation method or a mix of different strategies. This selection depends on the investor’s age, goals, risk tolerance, and market expectations.
But, do remember that this article provides just the basic guidelines on how investors can use asset allocation. Be aware that asset allocation strategies which involve forecasting and responding to market shifts demand talent and expertise. This primarily consists of the flair to use specific tools to time the market movements. Some claim that timing the market accurately is not possible. Hence, ensure that your approach isn’t vulnerable to unexpected errors.