Understanding the Basics of Asset Allocation and How it Works

Understanding Asset Allocation and How It Works

Most investors hold different securities in their portfolios, seeking to diversify risk. Due to their different level of risk, asset classes react differently to market fluctuations. For example, stocks tend to fluctuate more than bonds; thereby they are considered a riskier investment. Large caps normally incur a lower risk because they are global brands, perfectly positioned for value investing. On the other hand, there are high-growth startups that can serve the short-term goals of a growth investor. So, it all boils down to how you have constructed your portfolio using assets that match your investor profile. In other words, your goal is to achieve the optimum asset allocation.

Understanding asset allocation

The expected return on your portfolio is the weighted average of the stock returns of all securities. The weights are proportional to the amount of money invested in each security. That said, consider that you have a portfolio consisting of the following assets: 60% U.S. equities, 15% short-term bonds, 10% emerging equities, and 15% mutual funds. What you are trying to do is using asset allocation to spread the risk among the different asset classes and gauge your investment. Especially, in volatile market conditions, asset allocation can be a great leverage tool to anticipate the market fluctuations and increase the return on your portfolio.

Aggressive or Conservative? 

Assume that you want to save for retirement. Since your financial goal is long-term, you should create an aggressive, growth-oriented portfolio. Even if you incur losses, you have more time available to recover than if your investment horizon is 2 to 5 years. That said, if your financial goal is short-term, like buying a new car, you should invest in a conservative portfolio.

Here are two examples to better understand how asset allocation works:

As you can see, the aggressive portfolio invests about 68% in equities, 18% in mutual funds, and 14% in bonds. Conversely, the conservative portfolio invests about 37% in equities, 9% in mutual funds, and 54% in bonds. So, the difference is the gauging factor is your investment horizon.

Investment Horizon

The investment horizon is very important when leveraging risk. If you have a long-term horizon, you are more likely to select an aggressive mix of equities and bonds, expected to provide higher returns. In addition, aggressive portfolios are more likely to outperform inflation. For example, if the inflation rate is 2%, it may be 5% after 20 years, but the value of money will not be the same after 20 years. By investing in a dynamic portfolio, you will outperform inflation on maturity. 

On the other hand, short-term investors tend to invest in conservative portfolios. Higher allocation in a conservative asset mix such as bonds and money market funds is more likely to preserve your funds. However, you should also consider equities for portfolio growth. In both cases though, as the funding date approaches, you should shift your assets to more conservative options to lower the risk of market fluctuations. 

Risk Tolerance

Most investors are risk-averse, which means that they refrain from a higher investment risk unless they expect to be rewarded with a higher return.

Conservative investors invest in fixed income securities and low yield assets, rather seeking for value than growth. Value investors choose large caps, dividend-paying companies that can provide them with a steady stream of income. In the above example, a value investor would probably not invest in emerging equities for more than 5%.

On the other hand, aggressive investors are willing to invest in riskier equities, expecting a higher growth in their portfolio. Growth investors choose high-growth startups, technology stocks, healthcare ETFs and alike investments that may incur a higher risk but are more likely to provide them with significantly higher returns.

Strategic Asset Allocation

Strategic Asset Allocation refers to strategically select your investments so as to achieve your long-term financial goals. Although it may sound straightforward, it requires you to have a good knowledge of the market and a certain tolerance for risk.

The first step in strategic asset allocation is to allocate your funds across equities, bonds, mutual funds, and cash so as to ensure optimal returns given the level of risk you are willing to accept. Then, you should diversify within each asset class. For example, when investing in equities, you can diversify across different geographical regions or between growth and value equities or government and corporate bonds. For example, you can invest in international equities in Brazil, Switzerland and the UK through ADRs.

Geographical dispersion is widely used in asset allocation strategies, especially through ADRs that incur no currency risk. Finally, make sure to rebalance your portfolio regularly. Rebalancing means to change the allocation across the assets to achieve optimum returns given the market conditions. For example, if your portfolio invests 20% in a stock that over time loses in value, you should replace this stock or lower its weight in your portfolio with a winning one. 

The Bottom Line

Asset allocation is a dynamic investment strategy that allows you to create a well-constructed portfolio and meet your investment goals. The strategy is widely used for risk diversification because losses incurred from under-performing securities can be traded off by gains incurred by over-performing securities. However, you should keep in mind that rebalancing can offer you great returns because it capitalizes on the changing market conditions. Finally, well-diversified portfolios offer a higher growth in less volatile markets and ensure higher returns in the long-term.

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