Asset Allocation is the strategic mix of financial securities (equities, bonds, real estate) in an individual’s investment portfolio. The primary objective of Asset Allocation is to maximize returns while minimizing risk. The percentage of allocation for each asset class is determined by the investor’s overall risk appetite and tolerance, and not necessarily the level of investment.
If you have a low tolerance for risk and a very conservative risk appetite, you will invest $1,000,000 the same way you would $10,000. Being aware of your risk appetite and tolerance is the foundation for every investment decision. Your risk tolerance is the amount of loss you’re willing to actually accept versus your risk appetite which is the amount of potential loss you’re willing to be exposed to.
One way to determine your risk appetite is setting a Risk Baseline.
Establishing a risk baseline will outline the amount of loss you will be able to withstand financially. This will also contribute to the general weighting of your investments across your portfolio.
Diversification is key and a main factor in asset allocation.
Concentrating all your investment in one area runs you at a higher risk to lose everything and over-diversifying, can negatively impact your portfolio. Yes, investing in different sectors is beneficial but spreading the investment too thin can reduce the quality of the overall portfolio. For example, in a portfolio with thirty securities, you may have ten that are performing exceptionally, and twenty that have a below-average performance. That of the twenty may significantly dilute the value of the overall portfolio. Diversification is therefore is not necessarily done to maximize gains, but to minimize risk.
Another key factor to consider in asset allocation is your need for liquidity.
Along with your risk appetite and your risk tolerance, you will need to select your ideal time horizon, whether you desire to invest short-term, intermediately, or long-term.
For investments to be easily liquidated, individuals should typically place a higher percentage of their assets into a class that holds mainly short-term fixed income securities. Though this low-risk, it will generally yield comfortable returns for your portfolio.
Asset classes yielding higher risks along with higher returns making up the majority of the portfolio, may appeal more to an investor aiming to gain more over a longer time.
Below is an example of a portfolio belonging to a moderate investor with an intermediate time horizon.
15% Bonds
35% Large-cap equities
25% Small-cap equities
25% Cash & equivalents
All in all, asset allocation is involved in every aspect of the investment stage.
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