Think of it as the opposite of putting all your eggs in one basket. Allocating your investments to different asset classes is an important strategy for minimizing your risk and potentially increasing your profits.
What is asset allocation?
Asset allocation means spreading your investments across different asset classes. Broadly speaking, that means a mix 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 of more than $10 billion.
- Mid cap stocks: Shares issued by companies with a market cap between $2 billion and $10 billion.
- Small Cap Stocks: Companies with a market capitalization of less than $2 billion. These stocks typically carry a higher risk due to their lower liquidity.
- International securities: Any security issued by a foreign company and listed on a foreign exchange.
- Emerging Markets: Securities issued by companies in developing countries. These investments offer high potential return and high risk due to their country risk potential and lower liquidity.
- Fixed Income Securities: High-quality corporate or government bonds that pay the holder a fixed amount of interest periodically or at maturity and repay principal at the end of the period are less volatile and less risky than stocks.
- Money Market: Short-term debt investments, typically one year or less. Treasury bills (T-bills) are the most common money market investments.
- Real Estate Investment Trusts (REITs): Shares in an investment pool of mortgages or properties.
Key learning points
- Your ideal asset allocation is the mix of investments, from the most aggressive to the safest, that will deliver the total return you need over time.
- The mix includes stocks, bonds and cash or money market securities.
- The percentage of your portfolio you spend on each will depend on your time frame and your risk tolerance.
- This is not a one-time decision. Review your choices from time to time to see if they still meet your needs and goals.
Maximizing return and risk
The purpose of allocating your assets is to minimize risk while achieving the expected return. To achieve that goal, you need to know the risk-return characteristics of the different asset classes. The figure below 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 offer the lowest return.
This is the trade-off between risk and return. High-risk choices are better suited to investors with a higher risk tolerance. That is, they can accept large swings in market prices. A younger investor with a long-term investment account can expect to recover in time. A couple nearing retirement or retiring may not want to jeopardize their accumulated wealth.
The rule of thumb is that an investor should gradually reduce risk exposure over the years in order to retire with a reasonable amount in safe investments.
Stocks have the highest potential return, but also the highest risk. Treasury bills have the lowest risk, but offer the lowest return.
That is why diversification through asset allocation is important. Each investment involves its own risks and market fluctuations. Asset allocation isolates your entire portfolio from the ups and downs of a single stock or class of securities.
So while one portion of your portfolio may contain more volatile securities that you have chosen based on their potential for higher returns, the other portion of your portfolio is devoted to more stable assets.
Decide what’s right for you
Because each asset class has its own return and risk, investors should consider their risk tolerance, investment objectives, time horizon and available money to invest as the basis for their asset composition. All of this is important because investors want to create their optimal portfolio.
Investors with long time horizons and larger amounts to invest may find themselves comfortable with high-risk, high-return options. Investors with smaller amounts and shorter timeframes may prefer low-risk, low-return allocations.
To make the asset allocation process easier for clients, many investment companies create a series of model portfolios, each consisting of different proportions of asset classes. Each portfolio meets a certain level of risk tolerance for 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 purpose of a conservative portfolio is to protect the principal value of your portfolio. That is why these models are often referred to as capital preservation portfolios.
Even if you are very conservative and are tempted to avoid the stock market completely, some exposure to stocks can help offset inflation. You can invest the stock 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 keep most of the portfolio’s total value, but is willing to take some risk for inflation protection. A commonly used strategy within this level of risk is called current income. With this strategy, you choose securities that pay a high level of dividends or coupon payments.
A moderately aggressive portfolio
Moderately aggressive model portfolios are often referred to as balanced portfolios because the composition of the assets is almost evenly split between fixed income and equities. 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 (typically more than five years) and a moderate level of risk tolerance.
An aggressive portfolio
Aggressive portfolios are mostly stocks, so their value can fluctuate widely from day to day. If you have an aggressive portfolio, your main goal is to achieve long-term capital appreciation. The strategy of an aggressive portfolio is often referred to as a capital growth strategy. To provide diversification, investors with aggressive portfolios usually add some fixed income securities.
A very aggressive portfolio
Highly aggressive portfolios consist almost entirely of stocks. With a very aggressive portfolio, your goal is strong capital appreciation over a long time horizon. Because these portfolios carry significant risk, the value of the portfolio will vary widely in the short term.
Customize your assignments
These model portfolios and the associated strategies can only provide a loose guideline. You can adjust the proportions to suit your own individual investment needs. How you tune the above models depends on your future financial need for capital and the type of investor you are.
For example, if you want to research your own companies and spend time selecting stocks, you will likely divide the stock portion of your portfolio further into sub-classes of stocks. This allows you to realize specialized risk-return potential within a part of your portfolio.
The percentage of the portfolio you spend on cash and money market instruments also depends 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, consider placing a larger portion 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 risk tolerance will have a smaller portion of their portfolio within these instruments.
Maintain your portfolio
When deciding 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 is important to perform a periodic review. That includes a consideration of how your life and your financial needs have changed. Consider whether it’s time to change the weighting of your assets.
Even if your priorities have not changed, your portfolio may need to be rebalanced. That is, if a moderately aggressive portfolio has recently seen a lot of gains from stocks, you could move some of that gains into safer money market investments.
It comes down to
Asset allocation is a fundamental investment principle that helps investors maximize profit and minimize risk. The various asset allocation strategies described above cover a wide range of investment styles, taking into account different risk tolerances, time frames and targets.
Once you’ve chosen an asset allocation strategy that’s right for you, remember to review your portfolio regularly to make sure you’re maintaining your target allocation and still on track for your long-term investment goals.