Sunday, 07 February 2010 18:01 Last Updated on Sunday, 07 February 2010 18:04
What is asset allocation?
One of the most important decisions for your investment portfolio is your choice of asset allocation. Asset allocation simply means spreading investments over a variety of asset categories, such as equities, cash or cash alternative investments, bonds, real estate, foreign securities, and possibly even precious metals and collectibles. How you allocate your assets depends on several factors, including your investment objectives, attitudes toward risk and investing, desired return, age, income, tax bracket, time horizon, and even your belief in what the market will do in the near term and long term.
Example(s): Let's say your investment objective is substantial asset growth, you have a 10- to 15-year horizon, and you are willing to assume a high amount of risk. You might choose to place a larger percentage of your funds in stocks of newer, growing companies that may offer higher return but involve a greater degree of risk. In contrast, another investor with a 5-year time horizon, whose objective is preservation of principal and who doesn't want substantial risk,may invest more heavily in government or banking instruments. Your asset mix, the specific investments you choose within each asset category, and the timing of your investments all play a part in your overall return.
The underlying principle in asset allocation is the documented observation that different broad categories of investments have shown varying rates of return and levels of price volatility over time. By diversifying your investments over asset classes, you potentially reduce risk and volatility. Generally, downturns in one investment class are expected to be tempered (or even offset) by favorable returns in another. Just as using different asset categories within a portfolio has the potential to reduce your risk, your choice of individual assets within a class can do the same. For instance, choosing stocks from different industries (e.g., automotive, high technology, retail, or utilities) within your stock allocation can be less risky than investing all of your stock allocation in one industry or company.
Caution: It is important to note that asset allocation does not guarantee a profit or protect against loss in a declining market. Asset allocation is a method used to help manage risk.
Generally, the higher the expected return on an investment, the higher the risk involved in trying for that return. The longer your investment time horizon, the more volatility risk you may be able to assume,allocating more of your investment to higher-risk (aggressive) assets. With a longer-term investment horizon, you can ride out several economic cycles. A shorter time frame usually requires a more conservative approach because you have less time to try to recuperate from a market downturn. In that case, you may want to reallocate investments into a lower volatility mix of asset classes as the time approaches to convert your investments to cash for your particular goal.
Monitoring and rebalancing asset allocation
Your asset allocation may change over time; what was appropriate in the past may not be right today, and what works today may not be appropriate for you in the future. This can be the result of economic fluctuations and/or changes in your investment objectives. In addition, growth or decline within asset classes may cause your asset allocation ratios to shift. For this reason, it is important to monitor your asset allocation periodically and rebalance your portfolio as needed. Rebalancing your portfolio involves shifting funds from one asset class to another to return to the ratios you have determined are appropriate for your investment portfolio.
Example(s): Let's say that on January 1, you determined that your assets should be allocated to 60 percent stocks, 20 percent bonds, and 20 percent cash, and that you placed your investments accordingly. The stock market has a very good year, and due to growth in that category, you discover at the end of the year that your ratios have shifted. Now, 70 percent of your portfolio's value is in stocks, 15 percent in bonds, and 15 percent in cash. What should you do? Well, if you want to keep the same percentages you began with, you could sell some stocks and invest in bonds and cash instruments to bring your portfolio back into the balance you chose. The opposite would be true if stocks sank; you might sell another asset class and invest enough in stocks to return to your original percentage. Alternatively, you could direct any new cash you are able to invest into asset classes that now represent a lower percentage of holdings than you prefer.
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