Asset Allocation
Candlefocus EditorAsset allocation is designed to diversify a portfolio, which may help manage risk and increase return potential. It entails spreading investments across several asset classes, such as equities, fixed income, cash, commodities, and real estate. By mixing different types of investments, asset allocation helps to reduce the impact of volatility in any one asset class.
Within an asset allocation framework, it is important to identify how much of each asset class to include in a portfolio. An optimal asset allocation is based on two factors—the investor's risk tolerance and the expected return. Generally, younger, able-bodied investors can afford to take more risk and allocate money to stocks. Those nearing or in retirement will allocate more to bonds or cash and equivalents.
The modern portfolio theory suggests that investors should never put all of their eggs in one basket because it leaves them vulnerable to market conditions. After allocating to different asset classes, investors may need to further subdivide their assets by risk, such as large-cap stocks, small-cap stocks, and international stocks, to create a balanced portfolio.
Building a suitable asset allocation is a key step in assembling a portfolio that meets an investor's objectives. Strategic asset allocation is an approach in which portfolios are built to reflect pre-determined targets. Strategic asset allocation targets are chosen based on the investor's risk profile, investment goals, and holding period. This approach helps to reduce panic selling during down markets and minimize the investor's exposure to unsystematic risk.
Tactical asset allocation is another approach that seeks to move the portfolio out of stocks and into cash or bonds, depending on where the investor sees the greatest opportunity. This strategy can benefit investors who can accurately predict which asset class will outperform, as they can increase their exposure to that asset class, but it comes with more active decision-making, transaction costs, and short-term capital gains tax liabilities.
Asset allocation requires a long-term, disciplined approach to investing and should be regularly reviewed to ensure the portfolio remains in line with the investor's risk tolerance and investment goals. Having a well-diversified, balanced portfolio is a logical starting point for any investor, regardless of their level of experience.