What is an Asset Allocation?
Asset allocation refers to the practice of dividing an investor’s resources among different asset categories such as stocks, bonds, mutual funds, investment partnerships, real estate, cash equivalents and cash alternatives based on their goals, risk tolerance and investment horizon.
Whilst there is no guarantee that any particular combination of investments will be more profitable or less risky than any other, professional investment managers believe that an investor can lessen and control risk by diversifying an investment portfolio because each asset class has a different relation to the next.
Simply put, asset allocation is a solid diversification strategy with the purpose of maximising returns and minimising risk to further optimise an investment portfolio.
How does it work?
Asset allocation can be personally decided by an investor or they can seek assistance from professional financial planners who will assess their investment portfolio before suggesting the best solution on how to proceed with the said strategy.
When it comes to asset allocation, what is more important than the actual securities chosen is the ‘How.’ The amount of an investment portion placed into a specific class is established by asset allocation models that are designed to mirror the personal goals, risk tolerance, as well as the investment horizon of an individual. These models fall somewhere between four objectives:
- Preservation of Capital
This type of allocation model is for individuals who do not wish to risk losing even just a small percentage of principal value for the possibility of capital gains. They can expect to use their cash within a year, making this model suitable for investors planning on paying for college, purchasing a house or acquiring a new business.
A balanced portfolio is more for emotional reasons as allocations based on this model aim to strike a compromise between long-term growth and current income. The ideal result would be a combination of assets that generate cash and increases over time with smaller fluctuations in quoted principal value than the all-growth portfolio.
An example of an income-oriented investor is an individual who is probably nearing retirement and has set their mind that the need for cash in hand for living expenses is more important even though growth for the long term would be better.
For investors who are are just beginning their careers and determined to build long-term wealth, the growth asset allocation model would be the best choice. Compared with an income portfolio, the investor would be more likely to increase their allocation each year by depositing additional funds. Whilst growth portfolios tend to significantly outshine their counterparts in bull markets, the risk lies in bear markets where they are the hardest hit.
Financial markets these days are full of surprises and it is not easy for any individual to predict which asset class will go up or down. That said, investors should review their asset allocations at least once a quarter to determine whether they should stick with their current portfolios or look at rebalancing.
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