Everything You Ever Wanted to Know about Asset Allocation
What is an asset anyway?
It’s an interesting question, because no one ever seems to ask. In conversation, however, it becomes clear that our conventional misunderstanding can carry financial repercussions. Part of the reason for this is the term varies dependent on the situation being discussed. If you look up asset in Webster’s dictionary, you will notice multiple definitions, the primary definition is “an item of value belonging to an individual.” For today’s purposes, let’s think of assets in terms of money that you can use to buy anything that you hope either 1) goes up in value or 2) pays you an income.
Yes, I am talking about investments
Investing
For many people, investing typically begins with one stock or one bond or one mutual fund. Most people wait til that investment makes some money. Then with “house money”they expand into a 2nd. Over time, other selections are added. This is a natural occurrence because we all can understand the risk of putting all our eggs in 1 basket! (basically, no one knows what could happen next). However, just “spreading money around” in a haphazard way may create only an illusion of diversification. We call it building an investment buffet. You pick some this, add a little of that and over time fill your plate…
Asset Allocation
Your asset allocation should be targeted and individualized to fit you as a person, and to help you achieve your specific goals. Without goals and individualization you end up with a muddled sludge of stocks that can be financially destructive. When you assemble a “hodgepodge” portfolio, it may be difficult to evaluate the extent to which your investments are (or are not) consistent with your objectives.
This is where it gets tricky, because unfortunately it is much easier to relax and accept a mediocre asset allocation. The question is how you as an individual can actually excel in life instead of accepting the ordinary. How do you go about setting up a framework that tailors your investments to your particular circumstances?
Plotting Your Course
So going back to the main point, you have assets that you need to divide up correctly for future financial security. A sound portfolio management strategy begins with asset allocation. That is dividing your investments among the major asset categories of equities, bonds, and cash with a plan!
Since each investment category has unique characteristics, they rarely rise or fall at the same time. An optimal strategy means that no matter what the market does or does not do, your lifestyle will remain consistent. Overall, the goal is to combine different asset classes to help reduce risk, while improving the return of a portfolio.
Still, two nagging questions remain:
- What factors guide the asset allocation process?
- How much of a portfolio should go into each category?
Getting to Know You…
To answer the first question, it’s all about you, your portfolio needs to be personalized to you. Match the investment characteristics of the various investment categories to the most important aspects of your personal investment profile! That is, your tolerance for risk, your return and liquidity needs, and your time horizon.
Risk Tolerance
Investing according to your risk tolerance will help keep you from abandoning your investment plan during times of market turbulence. For example, if you have a low tolerance for risk, you may emphasize conservative investments over those that offer potentially higher returns. Both work equally well, but are for very different types of individuals. It also depends on how much maintenance you want to do. Higher risk investors will need to pay closer attention, and actually enjoy the thrill of following the market.
Return
Return refers to the income and/or growth you expect a portfolio to generate in order to meet your objectives. For example, retirees may prefer a portfolio that emphasizes current income, while younger investors may wish to concentrate on potential growth. Income stability is not the only factor, but it is a big one.
Time Horizon
Your personal time horizon extends from when you implement an investment strategy until you need to begin withdrawing money from a portfolio. Think of it as a sunset, if you start investing at five o’clock, taking a big risk before the sun goes down may be unwise since you don’t have time to wait for the market to go back up. For this reason, a short time horizon (less than five years) is probably best served by a conservative portfolio emphasizing the protection of principal. On the other hand, the more time you have to invest, the greater risk you may be able to withstand because you have time to recover from market downturns. The length of your horizon is directly correlated to your risk level.
Your Final Destination
Asset allocation is more a personal process than a strategy based on a set formula. However, there are guidelines to help establish the general framework of a well-diversified portfolio. For example, you may decide on the need for growth in order to offset the erosion of purchasing power caused by inflation.
Building an investment portfolio that is right for you involves matching the risk-return tradeoffs of various asset classes to your unique investment profile. One final point that is worthy of emphasis: You should consider all your assets when you put together your own asset allocation strategy (this includes your investments and retirement savings). This will ensure that all your assets are working in accord to meet your goals and objectives.
Asset allocation is like a game or a puzzle that requires a lot of consideration for a positive outcome, as always a good financial guide can assist.
