You can expect a change in your preferences as you age. What appealed to you in your 20s will most likely not appeal to you as you approach your 60s.
Your approach toward your investment portfolio is one of those things you can expect to change. Learn more about asset allocation and how you can build a more diversified portfolio.
What is Asset Allocation?
Asset allocation (AA) is an investment strategy geared toward building a diversified investment portfolio. It involves assigning specific asset class percentages based on your age, risk tolerance, investment potentials and goals. All of these factors are taken into account to balance risk and reward.
A smart investor is not a gambler, and you should never put all your money into a single asset. It’s important to divide your money among different types of assets.
Asset allocation (AA) involves dividing your investment portfolio among different asset categories, such as equities, cash and bonds.
Benefits of Asset Allocation
There are many benefits to asset allocation. These include:
- Better returns: A diversified portfolio consisting of different asset classes is most likely to outperform a non-diversified portfolio.
- Reduced risks: Asset allocation protects your portfolio from extreme losses. Since various assets react differently to market events, a diversified portfolio is a great way to reduce risks and maximize profits.
- Long-term investing: Asset allocation enables investors to make long-term investment decisions. When you allocate your assets, you think long-term and not base investment decisions on temporary market events or even emotion.
- Discipline: The long-term benefits in diversification of assets help you focus on the assets you need to achieve your goals while ignoring short-term, potentially stressful market fluctuations.
Asset Allocation by Age
The fact is, there is no ideal age to diversify or allocate assets to your portfolio. Every investor at any point of the investing cycle can employ asset allocation in varying percentages. A 25-year-old’s portfolio should be different from the portfolio of the parents or grandparents.
For instance, a young investor may use AA to make a high-risk, competitive growth portfolio. But an investor near retirement might use asset allocation to maintain a stable and fixed-income. AA may be utilized to build a vast array of unique portfolios, ranging from high risk to a more stable fixed income.
Age Appropriate Asset Allocation
Generally, stocks are recommended for long-term investment periods of up to 5 years or more. They are more suited for younger investors with plenty more years to spare. As people approach retirement age, portfolios must generally proceed to a more conservative asset allocation to help safeguard assets that have been gathered.
In the past, financial advisors have advocated subtracting an investor's age from 100 to ascertain how much should be invested in stocks. A 40-year old, for example, should look at investing 60% in stocks. For a 20-year-old, this would be about 80% in stocks.
Strategies for Asset Allocation
There’s no fixed rule on how an investor may approach asset allocation. Different financial advisors adopt different strategies.
The following are some popular approaches employed by investors to influence investment choices.
This strategy helps you maintain an asset mix to achieve the perfect balance between expected risk and return for a long-term investment timeframe. The tactical asset allocation objective here is to work toward a monetary target and avoid making short-term emotional conclusions based on current market events.
Dynamic investment strategy
Dynamic asset allocation allows investors to adjust their portfolios based on market movements, losses, and gains. It is the most common strategy today.
Unlike strategic allocation strategies, dynamic strategies will adjust positions over time relative to changes in the economic environment. However, this strategy also maintains exposure to its original assets.
Tactical Asset Allocation (TAA)
Tactical asset allocation is a technique where an investor chooses a more active strategy that attempts to position a portfolio into those assets, sectors, or stocks that show the most potential for perceived gains.
TAA has more flexibility in terms of movement in and out of their core asset classes and are often traded more actively. Ultimately, it provides more flexibility in dealing with the market dynamics so that the investors can focus on better-performing assets.
Before building your portfolio, it is necessary to understand the different assets and how they are grouped.
Assets are usually grouped into 3 main asset classes: equities, bonds and cash.
Equities are shares of companies, also known as stocks. They historically have the highest returns and come with the greatest risks.
Bonds are not as volatile or as high risk as stocks. They offer modest and more stable returns.
Cash and the likes of saving deposits, money market funds, treasury bills and more are the safest investment instruments, but also offer the lowest returns.
Tips: Although equities, bonds and cash are the 3 most popular asset categories, other asset categories like real estate and commodities exist. Cash and bonds are referred to as fixed-income investments. Equities, commodities, and real estates are growth-oriented investments and take a while to yield returns.
Asset Allocation Models
How you determine which assets to invest in and how much to invest in the various investment options is important. Allocation models help you understand different goals-based investment plans.
There is no right or wrong version — it is vital to go with what you believe best matches your targets and risk tolerance.
An income portfolio consists of dividends paying assets. An income portfolio could be a 100% bond portfolio or a 100% stock portfolio. An income allocation model will suit you perfectly if you are pursuing a short-midrange investment time horizon with minimal risks. However, dividends and returns are taxable depending on the account type.
A balanced portfolio invests in both stocks and bonds to decrease potential volatility. An investor looking for a balanced portfolio is more comfortable tolerating short-term changes and is satisfied with moderate growth. Such investors have a mid-long term investment time horizon.
A growth portfolio consists primarily of stocks expected to appreciate and bring high returns. This portfolio type is best suited to investors with a high-risk appetite and a long-term investment time horizon.
Diversification and Rebalancing Your Assets
Filling your portfolio with diverse groups of assets means you have a better chance of limiting losses and reaching your financial goals.
Rebalancing Your Assets
Some investments tend to grow faster than others. When this happens, you have to adjust your portfolio to ensure you don’t overemphasize one asset.
Rebalancing merely is bringing back your portfolio to your predetermined asset mix. Rebalancing in asset allocation is important because most investors on approaching retirement become risk-averse and may like to gradually shift from high-risk, growth-oriented assets like stocks to predictable fixed-income investments like bonds.
Best Financial Advisors
A financial advisor can help you choose the right asset allocation model and other investment advice. Take a look at our list of top financial advisors below.
Protect Yourself with Asset Allocation
Asset allocation protects your portfolio against significant losses. Historically, the returns of cash, stocks and bonds have never moved up and down at the exact moment. Market conditions that cause one asset category to do well often cause another asset category to have poor or average yields.
By investing in more than one asset category, you lower the risk of losing money and increase your portfolio's overall investment returns.
Frequently Asked Questions
Questions & Answers
Your asset allocation depends on your age, your risk tolerance and short- to long-term goals.
Based on these important elements, your assets allocation model can be:
- Income: if you’re a minimal risk individual pursuing short-midrange investment term
- Balanced: if you’re pursuing mid-long investment term and okay with moderate risk
- Growth: if you’re pursuing a long term investment and have a high-risk appetite
The 3 most important elements of asset allocation are age, risk appetite and investment goals.
By diversifying your portfolio, asset allocations help you to reach your long-term investment goals. It allows you to make constructive investment decisions and minimizes investment risks while yielding better returns on investment.
Assets allocation incorporates both passive and active investing. This makes it an efficient, potent and powerful tool for both traditional and individual investors.