Investing can be so scary when you are a new portfolio manager. An excellent investment plan depends on learning how to balance the risks and rewards while investing. This is an ideal position that can be realized through asset allocation. As such, this article will discuss the basics of asset allocation, why it matters and its important relationship with building diversified and resilient portfolios.
Meaning of Asset Allocation
Asset allocation is investing money into different categories such as bonds, stocks, cash, real estate etc. In this case, we spread investments across various types of assets to minimize risk while increasing returns. Investors use this strategy to diversify their investments so that they do not only invest in one area.
The main concept behind asset allocation is that each asset class has different levels of risk and return associated with it. Doing so lowers the impact any underperformance may have on your entire portfolio. For instance during stock market decline times; other assets like bond or land holdings may offset these losses.
Reasons for Asset Allocation
Proper asset allocation helps towards achieving long-term financial goals.It reduces investors’ portfolio risks exposing them to constant returns over time as well as minimizing volatility in the marketplace where these securities trade.The following reasons explain why people should practice asset allocation:
Risk Management: Diversification across several kinds of assets significantly reduces our overall portfolio risk.Mostly various markets behave differently depending on the prevailing market conditions hence their correlation coefficient value becomes reduced among them thus leading to spreading out investments over many groups reducing detrimental effects brought about by market volatilities.
Maximizing Returns: “Asset location” approach enables an investor to pick gains from each class one after another until he claims all possible total return available.This technique would help you find a good balance between profits & losses caused mainly out of purchasing shares, coupons etc.
Achieving Financial Goals: It also ensures that a diversified portfolio commensurate with your long term objectives as well as ability for taking risk exists.Thus, invests can be adjusted as per changing financial goals or investment appetite changes.
Classes of Asset
To have a well-diversified portfolio, it is essential to know which assets classes are there. Each class has its characteristics, risks and expected returns. The major asset classes are:
Stocks
Equities also known as stocks represent ownership interests in companies. Therefore, when you buy stock you purchase part of the company’s earnings and/or assets. However, despite the fact that they have high potential for long-term growth rates, these types tend to be more volatile due to significant price fluctuation on daily basis but buying different types of them allows minimizing exposure related with specific firm risks.
Companies, municipalities or governments can issue fixed income instruments. By purchasing bonds, you are lending money to the person that sells them and in turn the issuer rewards you with interest at regular intervals and also repays the principal amount on its maturity date as stated on its certificate. In contrast to stocks which have high volatility rates, bonds are low volatile because they make regular coupon payments. Typically, they offer lower returns than equities.
Real Estate
Investing is a term used when referring to residential, commercial or industrial properties purchases. Real estate is an investment that creates stable cash flow through rent collections and that might appreciate over time (Nakano et al., 2017). On the other hand, investing in real estate is more dangerous because one has got to invest large amounts of money initially; though it allows for diversification and is used as a hedge against inflation.
Cash And Cash Equivalents
For instance savings accounts qualify as cash equivalents together with money market funds as well as short-term government security. These investments are generally safe while at the same time providing high liquidity needed for diversification purposes. They will usually pay less than other kinds of assets but remain constant and conveniently liquid throughout their existence.
Determining Your Risk Tolerance
Before using any asset allocation strategy it’s vital to have a clear understanding of your risk tolerance levels. This could be how much an individual’s investments can change without making him feel uneasy about them in future years (Risk Tolerance). Factors such as desired level of financial success around horizon years before seeking out investment opportunities providing ROI (Risk Tolerance) among others like personal preferences may influence this.
Financial Goals; significant dreams concerning personal finance in relation to risk capacity may assist with making decisions here(Risk Tolerance). For example someone who has long period until retirement can take more risks since he would still have enough time before he/she stops working(Risk Tolerance). Conversely if one needs to buy a home and has several years’ time ahead, he/she will choose conservative approaches only (making a conservative approach).
Investment Horizon; the period of time for which one wants to expose his money determines how much risk one can take when investing (Risk Tolerance). When investments run through long periods, greater losses are incurred while they grow significantly over such periods with increasing scale implying higher chances of larger wins(Risk Tolerance).
Personal Preferences: The level at which people are comfortable investing their money defines their risk tolerance(Risk Tolerance). There are individuals who cannot afford it and hence they would rather use more conservative investment strategies (RISK CAPACITY) while some others may not do anything that will make them miss the biggest return on their investments.(Risk Tolerance) As a result every investor should be able to determine their own risk tolerance levels and find the right combination of assets.
Creating A Diversified Portfolio
Now that you know what asset allocation means and understand your ability to bear risks, it is time for you to start diversifying your holdings. How do you go about it? Here are six steps:
Step 1: Define Your Financial Goals
Begin by writing down what you want to achieve financially. Do you need savings after retirement, purchasing a house or paying fees for your children’s university education? Based on these objectives, an individual can come up with an asset allocation strategy that works best for him or her.
Step 2: Assess Your Risk Appetite
The amount of money you believe will be made from investment as well as at what time of the year would be the most appropriate for this can determine how much risk you are willing to take on. From here one may decide which combination of asset classes would work better within their portfolio.
How?
Step 3: Classifying Asset Classes
In such a case, you can select what is right based on these considerations and the types of asset classes you are dealing with (Jenkins & O’Leary, 2006). It’s the mix of common stocks, bonds, real estate and cash equivalents that helps diversify and upholds the integrity of many investors in making their investments.
Step 4: Apportioning Securities
To determine percentages for each class in relation to total portfolio size unlike in example above an investor not having high risk tolerance may place forty percent in equities while another forty percent will go into investment grade bonds. This shall leave ten percent both for real estate and cash balances (Bodie et al., 2008). On the other hand if it was an aggressive investor then approximately seventy percent would be allocated into stocks assuming say twenty percent were put towards bond holdings; five per cent left aside for real estates whereas cash gets double that figure.
Step 5: Rebalance Portfolio Again
So as not to stray from your financial objectives or risk tolerances it is advisable that your portfolio needs constant reviewing and balancing. As time goes by relative performances between various kinds of assets cause changes in allocation within your portfolio. This “rebalancing” process requires rebalancing to achieve required allocations.
Step 6: Monitor and Adjust
Thus keep checking so as to know how well they are performing over a period of time. Familiarize yourself with current market trends and economic conditions that could affect these investments. Also where there are any changes due to either risk tolerance of financial goals it is necessary to reallocate assets.
The Role of Professional Financial Advisors
At this point, one might still design a reasonable asset allocation plan, but engaging a professional financial adviser goes beyond that. The financial advisor has acquired unique skills in designing individual asset mixes that are tailored to the needs or objectives of an individual client and assisting with rebalancing ongoing portfolios.
Well-known Asset Allocation Strategies
Since investors have different investment goals and risks they can select their preferred asset allocation strategy. They include:
Strategic Asset Allocation
Within each of these classes there could be target allocations based on risk tolerance or financial goals (Kannan & Harikumar, 2013). Accordingly invest for long time frames but occasionally reposition holdings back to the target percentage.
Tactical Asset Allocation
This enables investors adjust their positions in response to underlying economic factors or market trends (Carlson et al., 2009). For instance, new possibilities would be identified before investing in them. However, getting familiar with swings may help when wanting higher risks so as to increase returns if possible.
Dynamic Asset Allocation
This means altering your portfolio’s composition from time to time due to prevailing investment concerns, risk tolerance and return requirements. Hence continue checking for any changes and adjusting investments accordingly.
Benefits of Portfolio Rebalancing
Portfolio rebalancing should be an element in a successful asset allocation strategy (Kannan & Harikumar, 2013). There are several advantages to continuously adjusting your investments:
Risk: The level of risk in a portfolio can be maintained at the desired level through rebalancing. As such, portfolios deviate from their intended objectives over time. In this respect, any adjustments made through rebalancing assist one in returning to his/her targeted allocations and consequently maintaining risks at their levels.
Seizing market opportunities: You can capitalize on market opportunities and trends by reviewing and making changes to your portfolio periodically. This allows for purchase of undervalued securities while disposing off those that have moved beyond realistic valuations hence enhancing total returns.
Disciplined Investment Approach: Rebalancing supports disciplined investment approach by sticking to an investment mix plan across various vehicles (Carlson et al., 2009). Failure to make proportional adjustments may lead to emotional buying or selling decisions thereby derailing long-term investment goals set.
Conclusion
Asset allocation requires deep understanding at its best. By investing in multiple asset classes, you can manage risks effectively, maximize investment returns as well as attain financial targets which you may set. Therefore after assessing risk tolerance first consideration stock composition but ask yourself why did I avoid investing in individual stocks for many years? However once it becomes complicated one may need assistance from professional financial advisor.
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