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In an ever-evolving financial system, choosing the assets that will comprise an investor’s portfolio is an important task that will determine both its profitability and risk sensitivity.
With so many different options on the table, what are the criteria that investors should follow to establish the percentage that will be allocated into each of these available asset classes?
In this article, we discuss the intricacies of asset allocation, what it is, how it works, and the different strategies that investors can adopt if they decide to take a DIY approach when building an investment portfolio.
What Is Asset Allocation?
Asset allocation is a practice that involves spreading the money destined to build an investment portfolio into any of the many available asset classes found in the financial markets.
To make things simple, allocation refers to the exact weight assigned to each asset based on the investor’s preferences, financial goals, risk tolerance, and other similar factors.
The primary objectives of this task are to mitigate risks via diversification and to increase returns by allowing high-risk/high-reward assets to contribute without overexposing the portfolio to large losses.
Pro Tip: In a nutshell, asset allocation is the process of spreading your investments across different types assets in order to meet a certain investment goal.
How Does Asset Allocation Work?
The process of determining a portfolio’s adequate asset allocation typically starts by analyzing the investor’s mindset, goals, tolerance for risk, income, and other similar variables.
Once those variables have been appraised, it will be easier to determine which assets should be allowed to participate in the portfolio’s mix and which shouldn’t.
Another important step when spreading a portfolio across different assets is to research the historical performance and risk — typically expressed as the standard deviation of returns over time — to estimate the expected rate of return and the potential variability of those results.
Once all those factors are on the table, all that remains is to execute the required trades to set things in motion.
Over time, the performance of each asset class will likely create deviations between the actual weight of each and the percentage that is supposed to be allocated to them. When that happens, the portfolio must be rebalanced to make sure that both results and risks remain in line with the initial plan.
Here’s a simple example of how this would work in practice.
Let’s say that Julian has $10,000 that he would like to invest. He is a 30-year old engineer whose primary goal is to build a retirement fund. Since he is young and his investment horizon is quite long, he can afford to take some risks to increase the size of that fund as much as possible in the long term.
As a result, he decides to spread his $10,000 as follows:
- 50% of his holdings go to stocks
- 25% of his holdings go to cryptocurrencies
- 15% of his holdings go to high-yield corporate bonds
- 10% of his holdings are used to buy fine art
Based on the historical performance of each asset class, Julian has determined that he should anticipate a 17% annual return on his portfolio with an expected risk of 5% — this means that the return can be either 12% or 22%.
Twelve months after Julian built this portfolio, his stocks and cryptocurrencies have done pretty well but the same cannot be said about his corporate bonds. To maintain the portfolio’s expected return and risk within the initial boundaries, he goes on and sells some of his stocks and crypto assets and buys more corporate bonds to rebalance the portfolio to its initial design.
That is, in a very simplified way, how asset allocation works.
Types of Asset Classes
Assets are typically grouped into four large categories to facilitate the process of choosing how much money will go into each. Even though there are sub-groups, all the instruments that belong to each class share similar characteristics in terms of how returns are earned and the risks involved.
These are the major four asset classes:
- Cash & Cash Equivalents: This category includes physical cash, banknotes, and any financial instrument that can be turned into cash instantly or that expires in three months or less. Returns are low and so are risks.
- Fixed-income securities: This group is composed of bonds (all of their forms) and convertible securities primarily. The risks involved vary depending on the creditworthiness of the issuer but fixed-income investments are typically considered less risky than equities as borrowers have a higher claim compared to equity holders.
- Equities: This instrument gives the holder ownership over a portion of a business enterprise. The returns are more volatile than those of fixed-income securities and they can come in the form of capital gains or dividends.
- Alternative Investments: This is perhaps the most heterogeneous class of all as it is composed of assets that offer distinctive — in some cases unique — returns and risks when compared to each other and other asset classes. Some examples of alternative assets include real estate, cryptocurrencies, commodities, fine art, fine wine, and derivatives.
For more detailed information about asset classes, check out our asset classes guide to learn more about this specific topic.
Pro Tip: Traditionally, investors allocate their investments toward stocks, bonds, cash, and cash equivalents. However, investors can also look at alternatives such as real estate, cryptocurrencies, commodities, art, derivatives, etc. to have the right mix based on their investment goals, time horizon, and risk tolerance.
Asset Allocation Planning
Now that we have touched on what asset allocation is, there are many ways to determine the appropriate mix for an investor’s portfolio based on some of the factors that we have previously mentioned — i.e., risk tolerance, income, and financial goals.
Asset Allocation by Goals
This is one of the most common variables used to determine which asset allocation strategy fits an investor the best. Allocating by goals starts by defining what it is that the investor wants to achieve.
These goals can vary widely from one investor to the other but the most common ones would involve buying a house, building a retirement fund, funding a vacation trip, or setting money aside for college tuition.
Asset Allocation by Risk Tolerance
The second most popular variable used to determine the appropriate allocation mix is risk tolerance. To determine how much risk an investor can tolerate, most advisors ask several questions concerning the maximum drawdown that they might be willing to tolerate without panic selling, the kind of investments that the investor might feel prompted to say yes to, and his or her decision on how to allocate money earned from a windfall, among other odd inquiries.
Depending on the results of these tests, investors are typically classified as conservative (low-risk tolerance), moderate (can take some risks but not too much), and aggressive (willing to increase returns by taking extra risks).
Asset Allocation by Age
Finally, allocation by age is typically appropriate for investors who have started early in their journey or for those who need to live off what the portfolio can produce.
For the first group, the portfolio’s mix may vary as time goes by and different stages of their life kick in — i.e., getting married, having kids, or retiring — while for the latter group the mix is typically leaned toward producing income to cover essential expenditures.
Pro Tip: Remember that risk vs. reward is at the heart of what asset allocation is really about. Understand your goals and plan accordingly.
Asset Allocation Strategies
It is now time to get your hands dirty and build a diversified portfolio based on any of the criteria discussed above. But, how do you start? Here’s a list of three basic portfolio allocations that work for the three types of investors mentioned above.
Keep in mind that these portfolios don’t incorporate alternative investments as the individual assets that comprise this particular group tend to be quite heterogeneous in terms of the risks and returns they have to offer.
For this reason, the percentage of the portfolio that is allocated to this group may be reviewed on a case-by-case basis for each investor and asset proposed.
The income allocation strategy is the best approach for conservative and late-age investors. The returns offered by this portfolio tend to be higher than those offered by cash but markedly lower than those offered by equities and alternative instruments.
Around 80% of the money that goes into this portfolio will be poured into fixed income securities (spread across multiple types) while the remaining 20% will be invested into high-quality stocks — also known as blue chips — or dividend stocks.
The risk of this portfolio is fairly low and its primary goal is to generate a stream of income for the holder. Examples of income allocation:
- 100% bonds
- 20% stocks / 80% bonds
- 30% stocks / 70% bonds
This is the perfect portfolio for investors with moderate risk tolerance as it incorporates some stability via fixed-income securities (around 50%) while increasing returns over time through the addition of variable-income securities like equities (50%).
The returns offered by this portfolio allocation strategy come mostly in the form of capital gains but income is also obtained in the form of both dividends (from the stocks that comprise the portfolio) and interest from the bonds it is invested in.
For this strategy, there might be room to incorporate a 10% allocation on alternative investments that could be taken off the equities portion of the portfolio. Moreover, depending on whether the investor wants to take on some more risks or not, the fixed-income portion of the portfolio could prioritize high-yield investments like junk bonds rather than low-yield alternatives like Treasury bonds. Examples of balanced allocation:
- 40% stocks / 60% bonds
- 50% stocks / 50% bonds
- 60% stocks / 40% bonds
Finally, the growth allocation strategy is mostly suitable for young investors and for those who need to increase the size of their portfolios faster than usual. One example of this latter group is people who are starting to work on their retirement fund late.
Since they have skipped most of the contributions they should have made years ago while also missing out on the compound interest they would have earned, they will typically adopt this allocation strategy to accelerate things before the retirement age kicks in.
This strategy incorporates a higher percentage of equities (around 80%) and a fairly small percentage of fixed-income securities (approximately 20%). Moreover, this portfolio creates room for incorporating a larger portion of alternative investments — typically around 20% to 25%.
The risk carried by this portfolio is higher than that of the balanced alternative but returns should be higher as well. Examples of balanced allocation:
- 70% stocks / 30% bonds
- 80% stocks / 20% bonds
- 100% stocks
Rebalancing Your Asset Allocation
As we discussed previously, the process of rebalancing a portfolio must be carried out periodically based on how the value of the assets has fluctuated over time. For investors who adopt a do-it-yourself approach, this procedure must be carried out manually.
The process starts by analyzing how much of the portfolio is being allocated into the different asset classes mentioned above versus the percentage that was initially planned.
To rebalance the portfolio, an investor must sell a portion of the assets that have exceeded their initially planned allocation and buy underweight assets. As a result, the portfolio’s risk and returns will remain within the expected boundaries.
There are some tax considerations to be taken into account when performing this activity. With this in mind, if your portfolio is quite large, you should consider talking to a professional about the best course of action to reduce your tax bill and increase your invested capital by taking advantage of your capital losses.
Asset Allocation vs. Diversification
Diversification is an important part of asset allocation but it is not the only objective. Diversification alone involves spreading money across multiple assets without assessing the unique profile of each asset such as its historical returns and volatility.
Meanwhile, asset allocation uses diversification in the sense that money is spread across different groups of assets but following a particular goal or upon considering the investor’s financial situation, tolerance for risk, and other factors.
In summary, asset allocation takes diversification to the next level as it is a more thorough and investor-centric approach to this fundamental concept of investing.
Pro Tip: Investing in more than one asset class will generally reduce the volatility in your portfolio. If one asset class is performing poorly, other non-correlated asset classes will counteract the losses with better investment returns.
Why Is Asset Allocation Important?
Asset allocation is a crucial concept primarily for long-term investors, not traders. The reason for this is that building a portfolio without considering the implications of incorporating different types of assets may expose investors to unexpectedly large losses and this may cause anxiety and frustration.
With this in mind, asset allocation accomplishes multiple goals including the following:
- It relieves the investor from second-guessing themselves about the assets they have incorporated into the portfolio;
- It creates a systematic approach to investment that typically yields positive results;
- It takes into account the unique characteristics of each investor, including their risk tolerance and financial goals; and
- It gives diversification a purpose.
Asset allocation is a cornerstone of investing as it allows investors to adopt a systematic approach to the process of building a portfolio. Now that you know the most relevant details about this practice, are you ready to build a portfolio on your own?
If not, you can always rely on the expertise of a professional or even a robo-advisor to help you out.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.