Asset Allocation – Everything You Need to Know to Choose the Best Allocation Strategy
Asset allocation is the act of choosing and combining asset classes in which to invest for the purpose of meeting a specific financial goal or investment objective.
A common asset allocation strategy is combining securities from different asset classes into one portfolio. How these different asset classes are mixed (and in what proportions) in a portfolio can give us a glimpse into the investment goals of the portfolio's owner.
Asset allocation strategies are usually tailor-fit to individual investment goals and perception of acceptable risk levels. Specifically, the specific asset allocation strategy an investor uses relies greatly upon his investment time frame and the level of risk he is willing to tolerate.
Consider Your Time Frame
How long can you wait before you cash in your investments? The answer to this is your time frame.
Do you have a long time frame? You have a long investment time frame if you're not planning to cash in the value of your investments in the near future. Long time frames often involves decades of holding on to a particular security.
With a longer time frame, you should be able to accept a higher level of risk. After all, you have the luxury of time and can ride out whatever market fluctuations occur in the short-term. If the market price of your stock falls, you can afford to wait for stock prices to come back up. In the long term, economic downturns are often countered by economic upturns, so everything tends to balance out.
Examples of investors with a long time frame are new graduates and young professionals. As a general rule, the younger an investor, the longer his investment time frame tends to be.
Do you have a short time frame? You have a short investment time frame if you are planning to cash in the value of your investments in the near future. Short time frames involve a period of a few to several years.
With a shorter time frame, you should probably choose a more conservative allocation strategy. In the short term, market fluctuations can highly depreciate the value of a security. Since you can't afford to wait out the disastrous effects of short-term market volatility, you should opt for less risky assets.
Examples of investors with a short time frame are parents saving up for their children's college education and middle-aged professionals saving up for retirement. As a general rule, the older the investor, the shorter his investment time frame tends to be.
Determine Your Risk Tolerance
Each of us has a different capacity for tolerating risk, especially when it comes to money. Asset allocation strategies, therefore, depend largely on investors' risk tolerance.
Different asset categories entail different levels of risk. Simply put, some investments are riskier than others. On the upside, riskier investments often entail greater potential investment returns. It's up to you to balance your investment return preferences with your risk tolerance.
Note, too, that an investment that claims a very low rate of risk yet promises a very high rate of return is probably bogus. You know what they say - what seems too good to be true probably is. It is not impossible for an investment product with a very low rate of risk to have a high rate of return, but it is still highly improbable.
Allocating Assets According to Financial Need
When deciding to allocate assets, you have to choose a specific allocation strategy depending on your investment time frame and risk tolerance. Apart from choosing an asset allocation strategy, however, you also have to choose a model of allocating assets. Your asset allocation model should be based on your specific financial needs.
A fresh graduate on his first job, for instance, probably has different needs from a retired widow. The former does not need to rely on investment returns for income and may even reinvest his profits from time to time. The latter, however, needs a stable and secure source of monthly income.
The following are some asset allocation models that fit different types of financial needs:
If you need a stable and steady source of income, you should probably choose an income-focused asset allocation model. In an income-focused asset allocation mode, the emphasis is on income generation rather than asset growth.
An income-focused asset allocation model is best for retired people who have no other source of income and have to depend largely on their lumped retirement pay or compensation package.
The optimal asset mix for this asset allocation model usually includes real estate properties, blue chip stocks issued by companies with a long record of regularly paying dividends to their investors, treasury notes and short-term time deposit accounts.
If you need a large amount of money for a long-term financial goal, you should probably opt for growth portfolios or growth asset allocation models. In a growth-focused asset allocation model, the emphasis is on asset building over time rather than generating regular income.
A growth-focused asset allocation model is best for young and/or aggressive investors who have a high tolerance for risk and a preference of high rates of return. Investors using growth asset allocation models usually don't have an immediate need for investment returns. They are often employed and have a regular source of income. They also often regularly set aside a portion of their income to add to their investments.
The portfolio of a growth-focused investor usually contains high-risk assets like stocks, junk bonds, international equities, and other assets that will maximize potential investment gains.
If you need both a regular income and money for a long-term financial goal, then you should probably go for a balanced asset allocation model.
A balanced asset allocation model balances growth needs and income needs. It is best for people who need regular income from their investments to supplement their current income but also need a large amount in the future to pay for a large purchase, to subsist on after retirement, or to use for their children's college education.
A balanced asset allocation model usually calls for a mixture of blue chip stocks from companies with a long track record of regular dividend payments, real estate holdings via REITs and bonds.
If preserving money is your main financial need, then you should probably choose an asset allocation model that focuses on capital-preservation rather than income generation and/or asset growth.
An asset allocation model that emphasizes capital preservation is perfect for people who have a large sum of money saved up that they plan to use sometime soon (say, for a home purchase). They often invest their money to safeguard it and make sure that they won't be able to use it for any purpose other than for which it is intended.
Investors who have a pressing need to preserve capital often invest in the safest asset categories; namely, cash and cash equivalents.
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