Asset allocation: An overview
Asset allocation describes the distribution of different asset classes within an investor’s portfolio. An investor, working with a trusted financial advisor, will determine which particular mix of stocks, bonds, cash, commodities, and real estate fits his or her financial strategy.
What is asset allocation?
Diversification is a linchpin in financial plans aiming to mitigate risk. Asset allocation, spreading one’s investment across a number of asset classes like stocks, bonds, cash, commodities, and real estate, helps diversify an investor’s portfolio. Determining the right asset allocation for a particular investor depends on that investor’s age, risk tolerance, and financial goals.
Assets typically fall into seven classes:
Cash: This describes both physical cash and cash you may have in a bank account. Fixed rate bonds, individual savings accounts, and short-term certificates of deposit (CDs) are all considered cash assets.
Real estate: This includes a home you own, an investment property, and land you purchased. Property and land.
Equities: These are stocks of publicly traded companies traded on the stock market. Ownership of shares entitles you to a portion of a company’s growth.
Bonds: Simply put, buying bonds is a loan to a municipality, a government, a company, or an institution which then pays you back with interest.
Peer-to-peer loans: This describes loans to an individual or business that needs seed money to thrive. In this scenario, it is expected that an investor’s loan will be repaid with interest.
Commodities: This asset class hinges on the price of materials such as precious metals like gold, agricultural products like soybeans and wheat, and energy products like oil.
Alternative investments: Wine, art, classic and exotic cars, jewelry, cryptocurrency – this asset class describes non-traditional financial investments.
Why is asset allocation important?
Asset allocation is important for investors to consider, because if done thoughtfully, it can help minimize risk while also allowing investors to generate wealth in their portfolios. Diversification of asset classes helps investors shield their capital from volatile swings in particular investments. If the stock market plunges expeditiously, for example, then it’s advantageous for investors to have put their money into bonds, commodities, and real estate that might be more stable at that particular moment in time.
By the same token, if alternative investments like cryptocurrencies tank but the stock market roars, it's helpful for the investor to have spread out his capital across equities and other asset classes to help weather a downturn in alternative investments. Asset allocation is all about trying to find the right mix of stock, bonds, and other asset classes to mitigate risk and boost gains.
Asset allocation by age
Age-based asset allocation is based on the premise that an investor can take on more risk when younger and less risk when older. A young investor looking to swing for the fences with a large percentage of risky stocks that could yield robust gains will have a longer time horizon to weather periods of downturn and recoup losses while also earning money in his or her career. Older investors have less runway to recover from market crashes and also must be careful to preserve capital in retirement when they are on fixed income.
Generally speaking, a younger investor’s portfolio will have a higher percentage of equities, which carry more risk, in their portfolio and a lower percentage of bonds. With life spans expanding, a good rule of thumb holds that the percentage of equities in your portfolio should equal 110 minus your age. That means, a 30-year-old should allocate 80% of his or her portfolio to equities. A 50-year-old’s portfolio, then, should only be 60% stocks.
Retirement asset allocation
As investors enter retirement and no longer have income from a job they can rely on, they typically dial down their exposure to risk in their portfolio by reducing the percentage of assets they hold in equities. As people live longer, they still want their assets to grow in order to afford the leisure and healthcare expenses as they age. But there is no one-size-fits-all plan for asset allocation in retirement, as investors may have different financial needs and goals in their post-work lives.
That said, investors are typically advised to keep the proportion of their portfolios dedicated to equities at 50% or less, while opting for 40% of assets allocated to bonds and 10% to cash. It’s generally considered prudent for investors to hold the cash they may need for the next five years in cash or investment-grade bonds with a range of maturity dates to allow for both long-term growth and greater immediate liquidity. It is also recommended that retirees keep six to 12 months of expenses on hand in cash as an emergency fund.
Asset allocation strategies
There are a host of asset allocation strategies investors can follow. It’s often worth consulting with a financial advisor to determine which asset allocation best suits your needs and financial goals.
Strategic asset allocation: In this buy-and-hold approach, investors set a particular target for what percentage of their funds that want to devote to each particular asset class. As their investments rise or fall depending on the market, investors can choose to rebalance their portfolio to make sure their portfolio is maintaining the right mix for their risk tolerance and financial goals. The framework helps investors stay disciplined in the long term without drastically changing their asset allocation based on knee-jerk reactions to market news.
Dynamic asset allocation: This is a much more hands-on approach that involves a fund manager actively manipulating an investor’s asset mix according to the medium- term vicissitudes of the market and the economy. Generally speaking, this strategy involves increasing the percentage of well-performing asset classes and reducing allocation of capital to asset classes that are doing less well.
Tactical asset allocation: A sort of Goldilocks medium between the more stagnant strategic asset allocation approach and the active dynamic asset allocation model. Though tactical asset allocation involves deciding upon set percentages for asset classes from the get-go, it allows for more flexibility in altering asset allocation according to breaking economic changes. Tactical asset allocation relies on trying to time the market, which carries with it some inherent risk, but those employing this technique will typically adjust to return to the original asset allocation once they’d executed a maneuver to try to maximize gains.
Constant-weighting asset allocation: If an investor opts to employ the strategic asset allocation approach, a change in the value of assets within particular asset classes will inevitably shift overtime and introduce an imbalance to the originally conceived asset mix. Enter constant-weighting asset allocation, which has investors consistently rebalancing their portfolios. If an asset drops in value, investors using this strategy buy more of it. This strategy, by the same token, dictates that people sell off assets that increase in value. Overall, this is a more active approach to maintaining the original asset allocation plan.
Insured asset allocation: For those with a low tolerance for risk, the insured asset allocation sets a floor under which the portfolio value should not drop. If the portfolio is growing, then the investor will manage it in an active manner. Yet if the portfolio ever drops below the predetermined floor, then it’s time for the investor to put his or her capital in assets with relatively little risk, like Treasury bonds, to guarantee returns and boost the portfolio back to its fixed base value. The strategy employees a stop-gap measure while also allowing some dynamic portfolio manipulation to mix up the allocation of capital to certain asset classes to try to maximize gains. \
Integrated asset allocation: This approach integrates both economic forecasts and personal risk tolerance when deciding upon the appropriate asset mix. Unlike the other strategies, this particular model centers the investor’s appetite for (or aversion to) risk as integral to deciding upon the proper asset allocation. Integrated asset allocation allows for some active investing but cannot incorporate both dynamic and constant-weighting allocation strategies which could be at odds with each other if employed at the same time.
Tips on how to allocate your assets
The ideal asset allocation will differ for each person. Beyond deciding which of the above strategies best suits a particular investor’s needs, it’s important to follow some fundamental tips when considering how to allocate your assets.
Be sure to alter your asset allocation mix according to your age
The way you invest at 25 should not be the way you invest at 65. When you’re younger and have your whole career in front of you, you can afford to allocate a large percentage of your portfolio to stocks and take it on the chin a few times during market crashes. A young investor will have time to recoup losses and thus can afford to be positioned in a riskier manner that could also deliver more robust growth.
When you’re older, it’s important to reduce your exposure to risk by reducing the percentage of your assets you’ve allocated to equities. Make sure you’re adjusting your asset mix as you move throughout your career.
Consider your true risk tolerance
Will a plummeting stock market trigger bouts of insomnia?
Will a crash in agricultural commodities leave a permanent pit in your stomach?
All investors want to reap the rewards of robust gains, but it’s important to be honest with yourself about how much appetite you truly have for risk in that drive to grow your portfolio.
If you’re a long-term investor who’s willing to roll with the punches, then by all means, consider allocating a larger percentage of your assets to equities. If you’re worried about losing sleep over the undulations of the market, consider adding a larger percentage of bonds to your mix.
Diversify within each asset class
Asset allocation is a fundamental way to add diversification to your portfolio and thus mitigate risk. But spreading out your assets across stocks, bonds, real estate, commodities, and the like is not enough. You need to make sure you’re invested in any array of investments within each asset class to ensure you’re not over-exposed to any one area or sector that could prove problematic should the floor fall out from underneath it. For equities, for example, consider investing not just in tech but in pharmaceuticals, industrials, retail, and banking.
By the same token, don’t just invest in American stocks; try to gain exposure to companies from Europe, Asia, South America, and Africa, for instance. Of course, take care not to over-diversify, lest you reduce your returns and add to your fund costs. Diversification is a key element to the investment analysis included in our services.
Consider a target-date fund
It can be satisfying to do your own research and toggle your asset allocation in an active way to try to maximize gains. But it can sometimes be advantageous just to opt for a target-date fund (also known as a life-cycle fund) that takes all the homework and sweat out of the process.
This is essentially a mutual fund proposition that allocates your money across a number of asset classes with an eye toward diversification and according to certain specifications you provide around your age and risk tolerance. The best part: it’s essentially a set-it-and-forget-it option. The fund automatically adjusts to reduce risk as you near retirement, typically the year you’ve targeted for your planned retirement. These funds, it should be noted, are a bit less limber in terms of allowing the investor to manipulate them according to personal circumstances. In addition, they can come with hefty management fees.
Think long-term
Do not let short-term jukes and pivots in the market persuade you to make rash changes to your asset allocation strategy. It can be tempting to try to time the market or chase short-term gains, but sticking to a long-term plan in your asset allocation and rebalancing according to your financial goals, personal circumstances, and risk tolerance may prove most beneficial.
Speak to an expert
There’s no need to go at it alone. Even for sophisticated investors, it helps to have an experienced voice of reason to help you determine what your ideal asset allocation looks like. For additional hands-on guidance, consider scheduling a meeting with a financial advisor.
Conclusion
Asset allocation refers to the distribution of capital across various asset classes within an investor’s portfolio. An investor will determine which particular mix of stocks, bonds, cash, commodities, real estate, peer-to-peer loans, and alternative assets fits his or her financial strategy. Asset allocation is important as a way to diversify one’s portfolio in order to mitigate risk while also encouraging growth.
Age, financial goals, and risk tolerance determine the exact mix of assets an investor might strive for in his or her portfolio. Typically, younger investors will introduce more risk their portfolios by having a larger percentage of equities in the mix – given their long time horizon to recover from any market downturn. Older investors or those already in retirement will typically reduce their exposure to equities and reduce the percentage of stocks in their portfolios to 50% or lower.
Depending on how active or passive investors wants to be, they can adhere to certain strategies that preserve the asset allocation determined to be ideal from the onset of their investment journey or rebalance assets in a more dynamic way to respond to ongoing economic factors and changes in personal risk.
All told, asset allocation considerations are a cornerstone in any savvy financial strategy.
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