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 to minimize 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.
The aim of asset allocation is to maintain the right mix of risk and reward by dividing the portfolio into diverse asset classes. The balance of risk and reward is decided on the basis of the individual’s financial goals, risk appetite, and investment horizon. The asset classes considered 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, then the financial advisor would advise him/ her to invest a higher proportion of 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 in the following types:
- Age Based Asset Allocation: This type of allocation is done on the basis of 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 on the basis of 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: In this strategy, the financial advisors follow the buy-and-hold policy. They maintain the weightage of each asset class constant by buying more of those assets that fall in value and selling those assets that appreciate it. Basically, the proportion of each asset class never deviates significantly from the original mix.
- Tactical Asset Allocation: This allocation strategy focuses on short-term high-return investment tactics, which helps the investors to cope with the dynamic market situation in a better way.
- Insured Asset Allocation: This type of allocation policy is suited for risk averse investors. In such an investment strategy, the investors have a certain pre-defined base value for the portfolio and if the value is breached then the investors take necessary actions to mitigate the risk.
- Dynamic Asset Allocation: It is one of the most popular investment strategies among investors as it helps them to re-balance their asset allocation on the basis of the ups and downs in the market or ongoing trends in the economy.
Examples of Asset Allocation
Following are the examples as given below:
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. In fact, they are of the belief that the selection of individual securities comes second to the strategy of assets allocation. Actually, 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.
Advantages of Asset Allocation
- It helps in the diversification of the investment portfolio.
- It assists in the achievement of the desired financial goals of investors.
- It keeps track of the riskiness of a portfolio.
Disadvantages of Asset Allocation
- In case there is a strong correlation among asset classes, then the process of asset allocation to diversify risk becomes a futile exercise.
- 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 with the decision of – 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 asset allocation work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –