Consider it the opposite of putting all your eggs in one basket. Allocating your investments between different asset classes is a key strategy to minimize your risk and potentially increase your returns.
What is asset allocation?
Asset allocation means spreading your investments across various asset classes. Broadly speaking, that means a combination of stocks, bonds, and cash or money market securities.
Within these three classes there are subclasses:
- Large Cap Stocks: Shares issued by companies with a market capitalization greater than $ 10 billion.
- Mid-cap stocks: Shares issued by companies with a market capitalization between $ 2 billion and $ 10 billion.
- Small Cap Stocks: Companies with a market capitalization of less than $ 2 billion. These stocks tend to have a higher risk due to their lower liquidity.
- International values: Any security issued by a foreign company and quoted in a currency.
- Emerging markets: Securities issued by companies in developing countries. These investments offer a high return potential and high risk due to their country risk potential and lower liquidity.
- Fixed income securities: Highly rated corporate or government bonds that pay the holder a specified amount of interest, periodically or at maturity, and repay the principal at the end of the period, these securities are less volatile and risky than stocks.
- Money market: Investments in short-term debt, usually one year or less. Treasury bills (Treasury bills) are the most common investment in the money market.
- Real Estate Investment Trusts (REITs): Shares in a pool of mortgage or property investors.
- Your ideal asset allocation is the combination of investments, from the most aggressive to the safest, that will generate the total return you need over time.
- The combination includes stocks, bonds, and cash or money market securities.
- The percentage of your portfolio that you dedicate to each depends on your time frame and your tolerance for risk.
- This is not a one-time decision. Review your options from time to time to see if they still meet your needs and goals.
Maximize return and risk
The goal of allocating your assets is to minimize risk while achieving the level of return you expect. To achieve that goal, you need to know the risk-return characteristics of the various asset classes. The following figure compares the risk and potential return of some of them:
Stocks have the highest potential return, but also the highest risk. Treasury bills have the lowest risk because they are backed by the US government, but they also provide the lowest return.
This is the risk-return trade-off. High-risk options are better suited to investors who have a higher tolerance for risk. That is, they can accept large changes in market prices. A younger investor with a long-term investment account can expect to recover in time. An approaching or retired couple may not want to jeopardize their accumulated wealth.
The general rule of thumb is that an investor should gradually reduce risk exposure over the years to reach retirement with a reasonable amount of money hidden in safe investments.
Stocks have the highest potential return, but also the highest risk. Treasury bills have the lowest risk but provide the lowest return.
This is why diversification through asset allocation is important. Each investment carries its own risks and market fluctuations. Asset allocation insulates your entire portfolio from the ups and downs of a single share or class of securities.
So while part of your portfolio may contain more volatile securities that you have chosen based on their potential for higher returns, the other part of your portfolio is dedicated to more stable assets.
Decide what is right for you
Because each asset class has its own level of return and risk, investors should consider their risk tolerance, investment objectives, time horizon, and money available to invest as the basis for their asset composition. All of this is important as investors seek to build their optimal portfolio.
Investors with a long-term horizon and larger sums to invest may be comfortable with high-risk, high-return options. Investors with smaller sums and shorter time frames may prefer low-risk, low-yield allocations.
To facilitate the process of allocating assets to clients, many investment companies create a series of model portfolios, each made up of different proportions of asset classes. Each portfolio satisfies a particular level of risk tolerance of investors. In general, these model portfolios range from conservative to very aggressive.
A conservative portfolio
Conservative model portfolios generally allocate a large percentage of the total to lower risk securities, such as fixed income and money market securities.
The main goal of a conservative portfolio is to protect the core value of your portfolio. That is why these models are often called capital preservation portfolios.
Even if you are very conservative and tempted to avoid the stock market altogether, some exposure to stocks can help offset inflation. You can invest the equity portion in high-quality, blue-chip companies or an index fund.
A moderately conservative portfolio
A moderately conservative portfolio works for the investor who wants to preserve most of the portfolio’s total value, but is willing to take some inflation hedge risk. A common strategy within this level of risk is called current income. With this strategy, you choose stocks that pay a high level of dividends or coupons.
A moderately aggressive portfolio
Moderately aggressive model portfolios are often referred to as balanced portfolios because the asset composition is split almost evenly between fixed income securities and stocks. The balance is between growth and income. Because moderately aggressive portfolios have a higher level of risk than conservative portfolios, this strategy is best for investors with a longer time horizon (generally more than five years) and a medium level of risk tolerance.
An aggressive portfolio
Aggressive portfolios consist primarily of stocks, so their value can fluctuate widely from day to day. If you have an aggressive portfolio, your main goal is long-term capital growth. An aggressive portfolio strategy is often referred to as a capital growth strategy. To provide diversification, investors with aggressive portfolios often add some fixed income securities.
A very aggressive portfolio
Very aggressive portfolios are made up almost entirely of stocks. With a very aggressive portfolio, your goal is strong long-term capital growth. Because these portfolios carry considerable risk, the value of the portfolio will vary widely in the short term.
Tailor your assignments
These model portfolios and accompanying strategies can only offer a flexible guideline. You can modify the ratios to suit your own individual investment needs. How you fit the above models depends on your future financial capital needs and the type of investor you are.
For example, if you like to research your own companies and spend time selecting stocks, you will likely further divide the equity portion of your portfolio into sub-classes of stocks. By doing so, you can achieve specialized risk-return potential within a portion of your portfolio.
Also, the percentage of your portfolio that you dedicate to cash and money market instruments will depend on the amount of liquidity and security you need.
If you need investments that you can liquidate quickly or if you want to maintain the current value of your portfolio, you might consider placing more of your investment portfolio in a money market or short-term fixed income securities.
Investors who do not have liquidity problems and have a higher tolerance for risk will have a smaller portion of their portfolio within these instruments.
Keep your wallet
As you decide how to allocate your portfolio, you can choose one of several basic allocation strategies. Each offers a different approach based on the investor’s time frame, goals, and risk tolerance.
When your portfolio is up and running, it’s important to do a regular review. That includes a consideration of how your life and financial needs have changed. Consider whether it is time to change the weighting of your assets.
Even if your priorities haven’t changed, you may need to rebalance your portfolio. That is, if a moderately aggressive portfolio racked up a lot of equity gains recently, it could shift some of that gain to safer investments in the money market.
The bottom line
Asset allocation is a fundamental investment principle that helps investors maximize returns and minimize risk. The different asset allocation strategies described above cover a wide range of investment styles, adapting to different risk tolerances, timelines, and objectives.
When you have chosen an asset allocation strategy that is right for you, remember to review your portfolio periodically to ensure that you are maintaining your intended allocation and are still on track towards your long-term investment goals.