Asset allocation is how you allocate your money to different asset classes e.g. stocks, bonds, cash. The mix you pick has a big impact on both your expected return and the amount of risk you are taking. Each person has an ideal asset allocation based on their investment strategy, goals, and risk tolerance.
The purpose of asset allocation
The overall goal of asset allocation is to achieve a certain expected return while maintaining a risk level that is in line with your risk tolerance and capacity. Including a mix of different assets in your investment portfolio allows you to diversify – you may buy large-cap stocks with a batch of long-term bonds, the idea being that the factors that cause large-cap stock prices to rise, will cause long-term bond yields to drop. They offset each other. You hedge your bets.
The mix of assets that you include in your portfolio will be divided between the different asset classes that exist. Examples of asset classes include:
As an investor, you need to decide what proportion of each asset class to include in your portfolio. Each of these asset classes has a different risk/return profile. Stocks, for example, are a riskier investment that offers higher returns. Cash, however, is a lot less risky but as a result, offers much lower returns.
Generally, assets in an asset allocation strategy differ by the kinds of companies that constitute the asset, the nature of the asset (bond, stock, etc.), the risk-reward ratio of the asset, and whether the assets behave in any particularly unique ways (such as the time decay in an options contract).
Within each asset class, you have a number of subclasses. Let’s say you decide to invest 60% of your portfolio in stocks. Great. Now you need to decide which stocks.
An example of correct asset allocation here would be balancing large-cap stocks with small-cap stocks, as well as international stocks. Although these are all growth-oriented stocks, by diversifying into different asset types you still gain the benefits of asset allocation.
Selecting the right mix
Your mix of assets will depend on 3 key factors:
- Your financial goals
- Your risk profile
- Your investment time horizon
1. Financial goals
We all have different goals for our investments – both short and long-term. Being clear about what it is you expect or require from your investments is key as it allows you to select assets that will get you to where you want to be.
2. Risk profile
How much risk can you handle? This question must be asked and answered from both an emotional and mathematical perspective. Your risk tolerance and risk capacity will affect which assets are candidates for your portfolio.
3. Investment time horizon
Are you a 32 year old with a long career ahead of you? Or are you a 50-year old that is heading towards retirement? The length of time that you wish to invest for is paramount to making sure that you have the right type of assets in your investment portfolio. A rule of thumb, for example, states that the younger you are the riskier you can be with your investments, as you have more time to correct downturns. But as you can see, there is no ‘one size fits all’ approach to asset allocation, as everyone’s goals, risk profiles, and time horizons are different.
Real-life examples of a mix
As an example of a potential asset allocation portfolio, consider the following asset mix. Assume that the investor wishes to try to reduce volatility and potential downside while also hoping to not put all their eggs in one basket for their growth-assets.
- 20% Large Cap US Stocks
- 10% Small and Medium Cap US Stocks
- 15% International Developed Market Stocks
- 5% International Emerging Market Stocks
- 25% Long-Term Bonds
- 10% Short and Medium-Term Bonds
- 10% Real Estate
- 5% Private Investments
In contrast, depending on your risk tolerance and goals a more simplified asset allocation strategy can also be utilized. For example, for an investor who simply wants to reduce volatility and downside to a small degree can pursue the following asset allocation:
- 60% Large Cap US Stocks
- 40% Long Term US Bonds
What’s right for me?
There is no ‘one size fits all’ approach.
Every person’s asset allocation strategy will vary depending on your desired rate of return, your risk tolerance, how much time you have to manage your portfolio, and how much understanding you have of different assets.
In many cases, a financial planner can be of great help in guiding you through the process of selecting what mix of assets constitute the correct asset allocation for you.