It has been a common thing to hear the words “Don’t put all your eggs in one basket” when investing. You should carefully consider these words especially when it comes to your investment assets. Asset allocation can help you in taking care of these said assets.
But first, what exactly is asset allocation? Did you know that there are also numerous asset allocation models that you can choose from? It’s no longer surprising to find out that asset allocation has become an integral part of investing especially in terms of portfolio management. But in order to max out the potential of this strategy, you must first understand its inner workings.
What is Asset Allocation?
In its most basic form, asset allocation is a type of investment strategy. It is mainly focused on balancing the risks and rewards. Asset allocation can accomplish such by allocating a portfolio’s asset based on your goals, risk tolerance, and investment horizon.
This can also be characterized by the amount of money you put into each of the investment categories. Research has shown that asset allocation is one of the most critical determinants of your portfolio’s success. It can help you diversify your portfolio. In this way, you can gain the highest return with the least risk over time.
There is a theory that revolves around asset allocation. The investors can lessen the risk since each asset class has a different correlation to the other. For example, when the stocks rise, most often the bonds begin to fall. While on the other hand, when the stocks fall, the real estate may begin generating above -average returns.
Most investors nowadays agree that asset allocation is one of the most important decisions you can make as an investor. However, it’s important to remember that there is no simple formula you can use to find the right asset allocation.
There are different models of asset allocation that can be used for different objectives. Risk tolerance plays an important role as well. Someone who isn’t comfortable investing in stocks can put her money in more conservative allocation despite a long time horizon.
Considerations when Allocating Assets
When making the decision to conduct asset allocation, there are some important factors you must consider. Here are some of them.
There are three main asset classes. These are: equities, fixed income, and cash and equivalents. These asset classes have varying degrees of risk and return, so they will most likely behave differently over time. Various asset classes include cash and currencies, commodities, stocks, and bonds. Even though some asset classes might not be as attractive you, diversity can still go a long way.
Different investments are accompanied with different growth possibilities. There are assets known as “value stock” which indicates the companies that have lower share price compared to its balance sheet value, profits, or cash flow. Another choice are “growth stocks”, companies in markets or industries that have great opportunity for considerably quick growth or expansion. There are also capital preservation investments such as bonds and some cash products. These are mostly designed to help you keep pace with inflation.
You can measure the size of a company you’re evaluation through capitalization. The market capitalization of a publicly traded company is usually determined by the value of the share price multiplied by the number of outstanding shares. Generally, large cap investments are considered to be more stable. Small cap investments on the other hand exhibit potential for larger growth. There are also mid cap assets that shows stability and some possibility for growth.
Sector and Industry
It’s also important to consider the industry you’ll be investing in. For instance, if the tech sector is struggling, the health products might be doing well. You should consider mixing up the sectors you have in your portfolio. This is to help keep you from over-exposing yourself in one sector or industry. Doing this will also limit the amount of losses you incur if you only invest in one sector or industry.
There are numerous types of bonds, but they are all considered as fixed income investments. The ones considered to be the safest are the U.S. Treasury bonds. The state and municipal bonds offer slightly greater risk and reward. Corporate bonds offer greater return but also greater risk that they’ll default.
This is the least risky asset class in the financial industry. Despite this, the return is negative once the cost of inflation is taken out. Under this category are money market funds and certificates of deposit.
There are various amounts of risks involved in commodities since there are also many types. However, it has been highly recommended for investors to own shares of an oil-related mutual fund. This way, the mutual fund should rise over the long term as the supplies continue to dwindle. It’s also advisable to not have no-more than 10 percent of allocation in gold.
The dollar experiences declines over the long term making it logical to own assets denominated in foreign currencies like euro. This can potentially protect you from the declines that happen in dollar.
These assets offer the highest risk and return. You should always keep in mind that it’s possible for you to lose more than your investment.
This includes the equity in your home, but most financial advisers don’t consider it since you live in it. Regardless, the value could still deteriorate. If you decide to foreclose, all of your investments will be lost. But it can also skyrocket which can force you to have too much in just one asset class.
These are considered to be riskier than bonds. This is mostly due to the fact that you can lose a hundred percent of your investment. As time passes, stocks offer the greatest return and will soon outpace inflation. Under stocks, there are three sub-categories that differentiate the stocks based on the size of capitalization. These are small cap, mid cap, and large cap.
Various Asset Allocation Models
Model 1: Balanced
A balanced portfolio is a compromise between income and growth asset models. Most people choose this type of asset model mostly due to emotional reasons instead of financial. The portfolios that use this model tend to meet halfway between long term growth and current income. For the result, it’s ideal for the mixture of assets to generate cash while also appreciating over time with smaller fluctuations in quoted principal value compared to an all-growth portfolio.
The division in balanced portfolios tends to be between medium-term investment-grade fixed income obligations and shares of common stocks in leading corporations. Most of the companies may pay cash dividends.
Model 2: Growth
This type of asset model is ideal for those who are just beginning their careers. Also, if you are interested in building long-term wealth, you should consider this model.
The assets in this portfolio are not required to generate current income. This is due to the owner being actively employed, which means that you use your own salary for required expenses. Unlike with income portfolio, you will likely increase your position annually by depositing additional funds. Growth portfolios also have different reactions based on the current market trend. During bull markets, growth portfolios tend to significantly outperform their counterparts. Meanwhile, during bear markets, growth portfolios are the hardest hit.
Most portfolio managers often include an international equity component. This is to expose the investor to economies other than the United States.
Model 3: Income
This asset allocation model is designed to provide a portfolio that generates income for the owner. It is mostly made up of investment-grade, fixed income obligations of large, profitable corporations. There are also real estate, treasury notes, and some shares of blue-chip companies that have a long history of continuously paying dividends
Most of the income oriented investors in general are those who are nearing retirement. Other investors also include those who are placed in certain situations wherein they’ll need to find another source of income in order for them to support themselves or their family. Growth may be considered to be a nice investment portfolio. Despite this, the need for cash in hand for living expense vies for the top priority at the moment.
Model 4: Preservation of Capital
This type of allocation model is mainly aimed at those investors who wish to preserve their capital. These people mostly means to use their cash within the next twelve months and refuse to lose even a small percentage of principal value for the possibility of capital gains. This allocation model is usually used by those investors who plan to pay for college tuition. There are also those investors who plan to buy a house, or acquire a business. These people will then turn to using a preservation of capital allocation model for their portfolio.
80 percent and up of these portfolios are mostly comprised of cash and cash equivalents and commercial paper. The biggest danger of using this asset allocation model is the possibility of not keeping pace with inflation. If the return you earned is not able to keep up with inflation, you may lose purchasing power in real terms.
Asset allocation is a highly suggested strategy that will help you better protect yourself and your portfolio. You can choose from various asset allocation models. The decision must meet your criteria and conditions in order to gain the best results.
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