Before we get into a discussion about asset allocation, it’s important to provide a definition so we’re all on the same page. According to Investopedia, asset allocation refers to the diversity of your entire savings and investment portfolio across asset classes. Stocks, bonds, cash and real estate are asset classes.
This investment strategy attempts to balance risk versus reward. It aims to do this by adjusting the percentage of each asset in the investment portfolio according to the investor’s risk tolerance, goals and time frame.
Another way to view asset allocation is to think about it as a synonym to portfolio diversification. While not exactly the same, they are similar. How? Asset allocation means spreading your money around in different places. The theory behind this strategy is that not everything moves in the same direction with the same magnitude at the same time. Thus by putting little pieces of your portfolio into different places to do different things, you’re minimizing risk in your portfolio.
Let’s take a couple examples to provide clearer descriptions. When your portfolio includes stocks, but also includes less volatile assets like bonds and CDs, you’re minimizing risk within your portfolio by smoothing out the rates of return.
Another example is U.S. investments versus international ones. While not a small piece by any means, the U.S. market is still just a piece of the overall world market. So, it’s a wise decision to invest your money internationally. Why? During some periods of time, U.S. markets do better than international ones and vice-versa.
How to Allocate Your Assets
Now that you know why it’s important to allocate your assets, let’s discuss how to do it. Essentially, you figure out your risk tolerance and use your time frame as a guide. Then, you spread your money out among the following:
- Stocks and bonds
- U.S. and international investments
- Large, mid, and small-sized companies
- Developing markets
- Precious metals
- Real estate
Your involvement within each allocation category will depend on your personal situation. Let’s look at two examples: precious metals and real estate.
Precious Metal and Real Estate Investments
People always ask about incorporating precious metals into their portfolios. This is even more common now during the pandemic. People feel more secure if they own gold. So, it’s always a good idea to have a percentage of precious metals. The higher the risk in your portfolio the greater the percentage of precious metals. The lower the risk in your portfolio, the lower the precious metal percentage.
Investing in real estate, for example, is just as dependent on your personal situation. Why? If you’re a contractor or a plumber or an electrician and are willing to do a lot of the facilities work within an investment property, building a portfolio of rental real estate might be a good idea for you. Or if you’re a high net worth individual and have property managers taking care of your rental properties, purchasing real estate would also work. But if you don’t fall into one of those categories and don’t want to be an active participant in real estate, a better option for you might be purchasing real estate investment trusts. This is like a mutual fund of real estate. This allows you to own real estate, but you don’t have to be actively involved.
What is proper asset allocation?
Not all asset allocation strategies will work for all people. Your personal situation needs to be considered when determining how to allocate assets within your portfolio.
Proper asset allocation is the process of selecting a mix of assets that aligns with an individual’s financial goals, risk tolerance and investment time horizon. The proportion of each asset class in a portfolio will depend on these factors.
For example, a young investor with a long-term investment horizon and a high tolerance for risk may choose to allocate a larger portion of their portfolio to stocks, which historically have provided higher returns over the long term but also come with greater volatility. On the other hand, an older investor approaching retirement may opt for a more conservative portfolio with a higher allocation to bonds, which tend to have lower volatility but also lower returns.
Proper asset allocation should be based on careful consideration of an individual’s unique circumstances and investment goals, and may require periodic adjustments as circumstances change over time.
Asset allocation is important to create a balanced portfolio
There is no simple formula for asset allocation. It needs to be based on the individual’s personal risk tolerance, where they are in meeting their retirement goals and what types of investments they hold. However, it is one of the most important decisions you need to make in order to achieve your financial goals.
Listen to our podcast on asset allocation to learn more about balancing your risk and return. As always the best decision you can make it to consult with a financial expert to coach and guide you through all of your decision making!