Whether you are a novice investor or a seasoned investor, you may be knowing some fundamental investing principles for successful investment decisions. Among these, asset allocation is a crucial one.
What is asset allocation?
It is an investment strategy for dividing investment among different asset classes in the portfolio by an individual investor or a portfolio manager to maximize returns.
For instance, how would you build a basketball team if you were a manager of a leading basketball club like FC Barcelona or Olimpia Milano? Would you spend money on 12 players like Michael Jordan, LeBron James, or Kobe Bryant? Though they are the best players in the world, a leading basketball team is not built with one type of player.
You need the best forwards, guards, and centers who are good at blocking, rebounding, shooting, and interior defence. Finding the right players with a blend of these skills will help you build a team that constantly delivers great results and success.
The same applies to creating an investment portfolio with the right mix of assets. It is not easy as there are thousands of investment options. Like building a basketball team with players of different skills, you need to create a portfolio with different asset classes like bonds, stocks, cash, and alternatives to increase the risk-reward from investments.
Nevertheless, the asset allocation that works out better at any time depends on some essential factors. They include:
- Time horizon
Your time horizon is the anticipated period of time, like the years or months, you will invest to reach a specific financial goal. Given that they can wait out slow economic cycles and the unavoidable ups and downs of markets, investors with longer time horizons may feel more at ease, making riskier or more unpredictable investments. An investor with a shorter time horizon, such as one saving money for a young person’s college education, would probably take less risk.
Hence, you have several decades or years with a longer time horizon, which may lead you to go for a higher allocation of equity funds or stocks, taking a considerable risk. With more potential for growth, it helps you attain your investment goals easily. A shorter time horizon does not give much time to recoup losses. Therefore, the asset allocation here includes cash assets that carry low risk.
- Risk tolerance
Your ability and readiness to lose part or all of your initial investment in exchange for higher potential rewards is called risk tolerance. An aggressive or high-risk-tolerance investor is more inclined to take a chance on losing money to achieve better results. An investor, who is conservative or has a limited risk tolerance, tends to select investments that would protect his or her initial investment.
For instance, significant market fluctuations are a common phenomenon of the financial cycle and as an investor, if you are uncomfortable with them and even aware of them, you probably have lower risk tolerance. Your risk tolerance is possibly high if you are investing for the long run and can handle market fluctuations. The proverbial expression “a bird in the hand” applies to conservative investors, while the “two in the bush” expression applies to aggressive ones.
The percentage of conservative and aggressive investments you hold determines your risk tolerance, which has a significant influence on asset allocation. This signifies how much of your holdings are made up of bonds, cash, and stocks.
You may have a more conservative portfolio based on your investing timeline, even if you enjoy taking on a lot of risks. For example, to help preserve the money you have accumulated during your lifetime, you may have a portfolio that largely includes fixed-income bonds if you are only a few years away from retirement.
Investment choices for asset allocation
You need to be aware that there are a wide variety of investment products available. They include stocks, bond mutual funds, municipal and corporate bonds, stock mutual funds, exchange-traded funds, treasury securities, and money market funds.
Investing in a mix of bonds, stocks, and cash be a useful strategy to promote capital growth and reach financial goals. Here are the three main asset categories that you need to know.
Equities or stocks are the most common elements of a standard investment portfolio. They are issued by public and private companies that let shareholders participate in ownership. You receive dividends for the stocks you hold. Stocks offer a higher potential for growth but are riskier. Their volatility makes them a risky investment for the short-term investor.
They are investment securities allowing investors to finance the companies and governments that issue the bonds. The issuer repays the money with interest on the maturity date. The returns on bonds are lower than those from shares because of less risk associated with them. Investors approaching short-term financial goals invest more in bonds for reduced risk and fixed returns.
Cash, as well as cash equivalents, is the safest asset of the three major asset classes. They include savings deposits, treasury bills, certificates of deposit, money market funds, and money market deposit accounts. They provide the lowest returns, but the likelihood of losing money on an investment in this asset class is very low.
An investor can guard against substantial losses by having asset classes with investment returns that fluctuate under various market conditions in a portfolio.