Asset Allocation

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Definition: Asset Allocation

Asset Allocation

Full Definition of Asset Allocation

Asset allocation is the dividing of one’s investment portfolio among different classes of investments. Asset allocation involves choosing among stocks, bonds, cash, and such assets as real estate and precious metals. Investors practice asset allocation to maximize their investment return for the level of risk they are most comfortable with; this frequently (but not always) involves diversification, which spreads risk among several investments. Asset allocation is also based on one’s investment goals, since different asset classes have different levels of risk and expected returns. Also, asset allocation can differ according to one’s age, since risk tolerance often decreases with age. Financial planners often help individuals with asset allocation by helping them clarify risk tolerance, investment objectives, and desired investment classes.

Building a portfolio entails combining different investments (in different percentages) to meet your financial goals. This is called asset allocation.

To build a portfolio, you need to take into account several factors about yourself. You also need to know what types of investments meet your needs.

Subjects to consider when building a portfolio:

  • Are You Investing for the Present or the Future?
  • Determining Your Risk Tolerance
  • Understanding Investment Risk
  • How Much You Are Willing to Put Into Your Investments?
  • Allocating Your Portfolio
  • Diversification Through Mutual Funds

Are You Investing For The Present Or The Future?

Since the odds are against your getting rich quickly or inheriting a million dollars, you will need to assess your financial situation carefully and then construct a portfolio so that you can build wealth over time. The first step in building your portfolio is determining your time horizon.

For the short-term, fixed-income investments and cash equivalents often have the highest returns. Cash, certificates of deposit and certain bonds are typically recommended for short-term investing. For the long-term, equities (stocks) have been shown to have higher historic returns than other investments. Therefore, if your time horizon spans decades, you may want to have a large percentage of stocks in your portfolio to maximize your return. Conversely, if you are investing for a shorter time horizon, it may be better to place your cash in more conservative (and less volatile) investments.

When building an investment portfolio it’s wise to keep the following considerations in mind: your current age, your immediate need for the money you are saving, and your assumed life expectancy. If you are 25 and don’t need to use the money you are planning to invest in the near future, it may be wise to allocate a larger portion of your investment dollars to more volatile and risky investments such as stocks. However, if you are a 70-year-old retiree and need income for the present, more secure investments such as bonds and other fixed-income securities may be more appropriate for you.

In general, the younger you are, the more risk you can afford. As you get older, you may want to increase the percentage of fixed-income securities in your portfolio. If your investments in stocks decline during a market downturn, your life expectancy could prevent you from regaining what you have lost.

Determining Your Risk Tolerance

Generally, the more risk you can tolerate, the more stocks you can put into your portfolio. What is risk tolerance?

Risk tolerance is the amount of risk with which you are comfortable when selecting your investment options. It is a key factor in building the investment portfolio that is right for you. Acting outside of your risk tolerance level could result in sleepless nights worrying about a rash decision you may have made.

Often an investor’s ability to meet their current financial responsibilities regardless of the results of their investment will influence their tolerance for risk. If you have a high net worth (and can, therefore, afford to lose some of your invested money), you may feel comfortable speculating in potentially risky investments such as currencies, options, futures and forward contracts. Conversely, if you have a low tolerance for risk (or few dollars to spare) it may be wise to stick to more conservative investments.

Yet, to understand risk as it relates to investments, it is important to have a concrete understanding of what investment risk is.

Understanding Investment Risk

Essentially, investment risk is the chance of loss due to the uncertainty of future events. Many factors can affect the value of your investments. For example, there are risks in political systems that can reduce the value of an investment. A Company you invest in may undergo unforeseen changes in management. Investor emotions may be unpredictable. Uncertainties in exchanges, rates of currencies, and in interest rates also affect investments. Usually, investors deal with risk in two ways: one is to simply guess at it, and the other is to study as many factors as possible and choose the most promising course of action. This latter option is called calculated risk.

Investment risk can also be measured by the volatility of an investment. The volatility is the amount that the price fluctuates above and below the previous price. Economists have developed a mathematical tool to “measure” this fluctuation. The Greek letter beta represents this measurement. A beta of one means that an investment is as volatile as the rest of the market. Investments with higher bets incur more risk with the opposite being true for investments with low betas. As you advance in your understanding of investments, you can use tools such as beta when choosing your investments. Until then, be comfortable knowing that understanding your risk tolerance is key to building the right portfolio for you.

How Much Are You Willing To Put Into Your Investments?

How much money you have (or want) to invest plays a big part in what your portfolio will look like. If you don’t have much, you may at first be limited to only a few investment options. Conversely, if you have plenty of disposable cash, you are open to a much wider choice of investments, including risky and expensive ones. An important step for all investors is to take inventory of all the valuable things they own (home equity, savings, insurance, jewelry, etc.), value them, and then figure how much of that value they are comfortable risking on investing.

Once you have determined your time horizon, your risk tolerance and the amount of money you can or want to allocate to your investments, you can get to work on creating a suitable portfolio. That is the subject of our next screen.

Allocating Your Portfolio

Diversification is usually the best way for investors to avoid losing lots of money.

Historical analysis of those portfolios having different proportions of cash, bonds, stocks and other assets reveals that, for a given return, there are optimal mixes of assets that produce different returns with minimal risk. These portfolios are considered to be “efficient” because they take the least amount of risk for a given return.

Once you understand the personal factors that are important to building your investment portfolio, you can begin to choose from the investment options that best fit your personal criteria. To select investments wisely, you should study how they work, how they are built and how they earn money.

Speaking of mutual funds, let’s conclude our tutorial on asset allocation by pointing out a unique feature of this investment.

Diversification Through Mutual Funds

Mutual funds are ready-made portfolios of investments. Mutual fund portfolio managers allocate the funds’ dollars in different ways to achieve different investment goals. For example, to meet the goal of growth, a manager may concentrate on growth stocks and allocate lesser amounts of the fund to bonds and cash. Since mutual funds are already set up with certain percentages of stocks, bonds and cash, you may be able to find funds that meet your personal criteria for diversification. If you do, which is likely because there are thousands of mutual funds in existence, you will save yourself the time and arithmetic of building your own portfolio. Asset allocation mutual funds, for instance, use formulas to alter the percentages of each type of security held as the market changes.

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Definition Sources

Definitions for Asset Allocation are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 18th April, 2020 | 0 Views.