As you examine your investment portfolio, you may notice a breakdown of all the different types of assets that you invest in. This is your asset allocation. It is the practice of dividing investments between different asset classes, such as bonds and stocks, to balance risk and reward according to personal investment needs. It is important not only to understand your asset allocation, but also to manage it.
Strategic asset allocation is the key to building and maintaining risk tolerance in your portfolio. It’s also the best way to ensure that you’re investing in assets that you understand and believe in. For most people, the asset mix is rarely fixed and will change naturally as assets appreciate and depreciate over time. Plus, a host of other factors (like your age) can dictate how you choose to allocate your assets. To that end, it’s worth understanding the ins and outs of the allowance.
Strategic asset allocation
The practice of strategic asset allocation consists of setting targets for distribution of wealth between different types of investments. In a typical portfolio, this includes cash, stocks, bonds, and commodities. Setting levels for each type of asset allows you to control risk and continue your investment thesis. Over time, an investor would then buy and sell different assets to restore the original allocation. This is a practice known as rebalancing.
What is rebalancing
Over time, the value of different assets will change. They appreciate and lose value at different rates. To stay true to an allocation strategy, investors need to rebalance. That implies sell and buy assets to realign the portfolio.
For example, let’s say your equity portfolio has an allocation of 50% biotech stocks, 30% telecom companies, and 20% financial stocks. After one year, the asset allocation of your portfolio can be 44% biotech, 28% telecom and 26% financial. To rebalance, you would sell financial stocks and buy the difference in biotech and telecom companies, to restore the allocation.
Rebalancing also does not always mean going back to the original allocation. The economic climate is changing, as are the investment objectives. Rebalancing is often a healthy way to reassess risk and redistribute wealth in a more beneficial way.
Allocation to control risk
Establishing specific allocations for each type of asset in your portfolio is a form of risk management. Each major asset class has its own inherent level of risk depending on volatility. Equities tend to be more volatile, which is why stocks are riskier investments than bonds – debt securities with little or no volatility. Asset allocation with these risk levels in mind looks very different depending on a person’s tolerance. Take for example these different allocations:
- Aggressive: 92% stocks, 2% bonds, 2% commodities, 4% cash
- Moderate: 80% equities, 10% bonds, 6% commodities, 4% cash
- Conservative: 65% equities, 22% bonds, 3% commodities, 10% cash
Investors looking to maximize potential gains will take more risk with a portfolio rich in stocks. Those with a lower tolerance for risk may opt for a more conservative allocation.
The most common form of asset allocation is age distribution. It’s a simple rule of thumb that says the older you are and the closer to the end of your investment horizon, the more conservative your allocation should become. Indeed, less time to invest means less chances of recovery in the event of negative volatility.
Conversely, young investors have a much longer time horizon in advance. Compound interest has more time to accumulate and the opportunity to recover in the event of an economic downturn. Young investors can and should bear the burden of risk allocation, adjusting as they age.
There is no such thing as a “perfect allocation”
While many financial advisers tout an “ideal allocation” or covert allocation formula, the fact is, there is no such thing. The optimal asset allocation depends on the person and the many factors in their life. Age, income, debts, outlook and dozens of other factors dictate a person’s risk tolerance and, inevitably, the allocation of their assets.
In addition, asset allocation requires an assessment at least annually. Investment factors change over the course of a year, forcing investors to reassess their risk capacity and their allocation thesis. It’s important not to let emotions come into play here. The concept of asset allocation consists of to delete emotional decision making of the investment landscape. An overly complex assessment of the allocation invites emotions to return, which can cloud an investor’s judgment.
Target date funds
Don’t have the confidence to maintain your own asset allocation? Enter: target date fund. These are asset allocation mutual funds that rebalance annually and change their allocation as they approach the target date. For example, if you invested in a fund maturing in 2035 in 2015, that fund would gradually rebalance over a 20-year period. Most target date funds switch from aggressive allocations to conservative allocations during their maturity. Many people use these funds as retirement engines because no manual rebalancing is required to adjust to risk.
The downside of target date funds is that they are algorithmic and adjust based on the fund, not the individual investor. You may have a higher (or lower) tolerance for risk than the fund’s balances at some point in its maturation cycle. It’s the cost of the convenience of automation.
Discover your ideal asset mix
Any long-term investor would do well to consider strategic asset allocation. Establishing risk and balance to manage your portfolio is a great way to take a practical, measured, and responsible approach. Programmed balancing is a good habit to build and can help you maintain a strong and diversified portfolio, especially when your risk appetite changes.
Asset allocation is essential for having a balanced portfolio that can lead you on the path to financial independence. To find out more, subscribe to Freedom through wealth e-letter below. You’ll get instant access to daily investing tips, analysis and more from some of today’s top experts on Wall Street!