Asset allocation is a common investment strategy that may be used to construct an investment portfolio. Asset allocation is focused on investing in multiple categories or industries. Mixing them together and assigning appropriate weights to match your financial goals, the time for investing, and risk tolerance.
Asset Allocation: The Basics
The main concept of asset allocation is based on the principle that not all investments are alike; you may balance risks versus return in your portfolio by dispersing your investments among different types of assets. Options available include stocks, bonds, as well as cash alternatives. Asset allocation does not guarantee a profit or 100% protection against losses, but it may mitigate these risks.
There are different types of assets, each of which having different levels of risk and return potential. Typically, they do not respond to market forces in the same way at any given point in time. As an example, when the return of one asset type is on a decline, the return of another may be rising. If the portfolio is diversified by investing in a variety of assets, a downturn in a single holding won't necessarily equate to a disaster or even a loss for the entire portfolio.
By using asset allocation, you identify the different asset classes that are appropriate for your personal circumstances. Following, you decide the percentage of your investment dollars that should be allocated to each class, for example 60 percent to stocks, 15 percent to bonds, 15 percent to cash alternatives.
Here's a glance at the three major asset classes that will generally be considered when using asset allocation.
While past performance does not guarantee future returns or performance, stocks have provided a historically higher average annual return rate compared to different asset classes (bonds or cash alternatives). However, stocks have been seen to be more volatile than the alternatives. Investing in stocks might be appropriate for your investment if your goals are over a longer period of time.
Historically speaking, bonds have been seen to be less volatile than stocks; conversely, bonds do not provide as much opportunity for growth where stocks would. Bonds are particularly sensitive to interest rate changes and are typically inversely proportional to each other in regards to their rise or fall. As a result, bonds redeemed before maturity may be worth more or less than their original cost. Due to bonds typically offering fixed interest payments at regular intervals, they may be appropriate if you want a regular lower risk income from your investments.
Cash alternatives offer a lower growth potential than other asset classes but are the least volatile of the three. Cash alternatives are subject to risks such as inflation, which in turn means chances are that the returns will not outpace rising prices. Cash alternatives do however provide more accessibility to funds than the longer-term type of investments, and may still be appropriate for investment goals that are short-term.
In addition to being able to diversify across asset classes such as purchasing stocks, bonds, and cash alternatives, you may also diversify within a single asset class. As an example, when investing in stocks, you can choose to invest in companies spread over multiple industries. Additionally, it may be chosen to divide your investment assets according to investment style, which can be investing towards growth or value. Though the investment possibilities are virtually endless, your financial objective is always the same: to diversify assets by choosing investments that balance both risk and reward within your investment portfolio.
Choosing Your Asset Allocation
The main objective of using asset allocation is to construct an investment portfolio that can provide you with the ideal return on your investment without exposing the portfolio to additional, unnecessary risk. The period of time able to be invested over is also important, due to the ability to ride out market adjustments over a longer period of time.
When trying to construct an investment portfolio, you may use worksheets or interactive tools that help identify and analyze your investment objectives, risk tolerance level, and investment time horizon. These tools may also provide model or sample allocations that strike a balance between risk and return, based on the information you choose to provide.
As an example, if your investment goal is to save for your retirement over a given time period of 20 years and are able to tolerate a relatively high amount of market volatility, a model allocation could suggest to invest a large percentage in stocks, and allocate a smaller percentage to bonds and/or cash alternatives. A good reminder is that models are intended to serve only as general guides; determining the right allocation for your individual circumstances may require more sophisticated, personalized financial analysis.
Building Your Portfolio
Your next steps are to choose specific investments for your portfolio that match your chosen asset allocation strategy. Those investors who are investing through a workplace retirement savings plan, typically invest through mutual funds; a diversified portfolio of individual securities is simpler to build through a separate account.
Mutual funds offer instant diversification within an asset class, and in many cases, the benefits of professional money management. Investments of each fund are chosen to be aligned with a specific objective or goal, making it easier to identify a fund or a group of funds that meet your financial needs and personal circumstances. When making an investment in a mutual fund, you should consider your time frame, risk tolerance, as well as financial objectives.
Disclaimer: Carefully consider investment objectives, associated risks, expenses, and fees before investing in a mutual fund. All of these may be found in the prospectus which is available from the fund; it is recommended to read through thoroughly before investing.
Your Portfolio Needs Attention
Once you have chosen and set your allocation, make sure to revisit your portfolio at least once a year (more often if markets are experiencing greater short-term adjustments). The reason to do this is to re-balance your portfolio when necessary. Due to market fluctuations, your portfolio may no longer reflect the initial allocation balance you chose. As an example, if the stock market has had a high performance, eventually you'll end up with a higher percentage of your investment in stocks than you initially intended. To re-balance, you may want to shift the new funds from returns to a different asset class.
Sometimes it may be required to rethink your entire allocation strategy. If you are no longer comfortable with the same risks, your financial goals have shifted, or you're getting close to the time when you'll need to withdraw the money, you may need to change your asset allocation.
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