Updated July 17, 2023
Definition of Asset Allocation?
The term “asset allocation” refers to the investment strategy used by financial advisors to apportion their client’s investment portfolios into different asset classes with the objective of minimizing the investment risk. The different asset classes behave in very different ways resulting in diverse levels of risk and return. It varies for each individual based on their preferences.
Asset allocation aims to diversify the portfolio into various asset classes to balance risk and reward. The individual decides the balance of risk and reward based on their financial goals, risk appetite, and investment horizon, considering asset classes that can be broadly divided into major categories.
- Conventional assets include equities, fixed income, and cash & equivalents.
- Alternative assets include real estate, commodities, etc.
How Does Asset Allocation Work?
Financial advisors use asset allocation to optimize the risk level of an investment portfolio according to an individual’s requirement by diversifying their funds into different asset classes. For instance, if an individual seeks a stable return, the financial advisor would advise him/ her to invest more funds into bonds. However, some portion of the fund will be invested into equity so that the investor also gets the benefits of investment in the stock market.
Types of Asset Allocation
Strategies can be categorized into the following types:
- Age-Based Asset Allocation: This type of allocation is done based on the age of the investors. Typically, financial advisors ask individuals to decide their investment proportion for the stock market by subtracting their age from a base value of 100. In such a scenario, the risk of a portfolio decreases with age as the investment in stock reduces.
- Targeted Dateasset Allocation: In this type of allocation, the investors maximize their return on investment based on various factors, such as investment goal, risk appetite, and age. Since every individual has a unique strategy, it is very difficult to standardize the structure across portfolios.
- Constant Weight Asset Allocation: The financial advisors follow the buy-and-hold policy in this strategy. They maintain the weightage of each asset class constant by buying more assets that fall in value and selling those that appreciate it. Basically, the proportion of each asset class never deviates significantly from the original mix.
- Tactical Asset Allocation: This strategy focuses on short-term high-return investment tactics, which helps the investors cope with the dynamic market situation.
- Insured Asset Allocation: This policy is suited for risk-averse investors. In such an investment strategy, the investors have a certain pre-defined base value for the portfolio. Investors take necessary actions to mitigate the risk if the value is breached.
- Dynamic Asset Allocation: It is one of the most popular investment strategies among investors as it helps them to re-balance their asset allocation based on the ups and downs in the market or ongoing trends in the economy.
Examples of Asset Allocation
Let us take the simple example of David to illustrate the concept over a lifetime.
He started his investment portfolio at the age of 25 years with an original mix of 50% in stocks and 50% in bonds. However, after a period of 5 years, one of his friends asked him to enhance his risk appetite and start investing more in stocks as the market is expected to perform well in the next couple of years. So, he changed the mix to 65% in stocks and 35% in bonds.
Again, after another 5 years, David got married, and he decided to tone down his risk tolerance as he needed a more stable income. So, he changed the mix to 35% in stocks and 65% in bonds. Therefore, it shows how the investment mix changes over a lifetime due to various factors in life.
Let us assume that David has created an investment portfolio as insurance for his retirement. He has $100,000 to invest for a period of five years. Determine the value of the investment in each asset class if he decides to diversify his portfolio across stocks, bonds, and cash at a mix of 35%, 50%, and 15%.
Based on the given information, the distribution of his investment across the three asset classes would be like this.
- Stocks: $35,000 (= 35% * $100,000)
- Bonds: $50,000 (= 50% * $100,000)
- Cash: $15,000 (= 15% * $100,000)
Importance of Asset Allocation
Most financial advisors believe that asset allocation is very important from the point of investment portfolio management. They are of the belief that the selection of individual securities comes second to the strategy of asset allocation. The right mix ensures that the outcome of the investment portfolio matches the requirement of investors in terms of risk and return. Although stocks, bonds, and cash are the principal components of any portfolio, the mix changes a lot based on personal objectives.
- It helps in the diversification of the investment portfolio.
- Assists in the achievement of the desired financial goals of investors.
- Keeps track of the riskiness of a portfolio.
- If there is a strong correlation among asset classes, then the process of asset allocation to diversify risk becomes futile.
- At times frequent changes in allocation can result in higher costs with no material benefit.
- It is a very complicated process.
So, it can be seen that asset allocation is a very important part of portfolio management as it helps decide where to invest and how much to invest. Successful implementation of asset allocation helps in achieving the ultimate financial goal.
This is a guide to Asset Allocation. Here we discuss the definition and how does it work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –