Learn the important concept of asset allocation in constructing your portfolio and avoiding investing risks.
Allocating Your Investments
Asset allocation is important because it has a major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or education for your children, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio.
Understanding Asset Allocation
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
Each type of asset has a level of risk and return associated with it. Stocks offer the potential for higher returns but also carry a higher level of risk. Bonds are generally less risky than stocks but offer lower returns. Cash and cash equivalents, such as money market funds, offer the lowest returns but also carry the lowest level of risk.
Importance of Asset Allocation
Asset allocation is important for several reasons. First, it can help you achieve your financial goals. By choosing the right mix of assets, you can increase your chances of meeting your financial goals. Second, it can help you manage risk. By spreading your investments across different types of assets, you can reduce the risk of losing money.
Lastly, asset allocation can help you stay on track with your investment plan. Once you've chosen an asset allocation strategy, it's important to stick with it. This can help you avoid making emotional decisions about buying or selling investments.
Factors Influencing Asset Allocation
Several factors can influence your asset allocation. These include your investment goals, your time horizon, and your risk tolerance. Your investment goals are what you hope to achieve with your investments. This could be saving for retirement, paying for a child's education, or buying a home.
Your time horizon is the length of time that you expect to hold your investments. If you have a long time horizon, you may be able to take on more risk because you have more time to recover from any losses. Your risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns.
Types of Asset Classes
There are several types of asset classes that you can include in your portfolio. These include stocks, bonds, cash and cash equivalents, real estate, and commodities. Each of these asset classes has its own level of risk and return.
Stocks, also known as equities, represent ownership in a company. They offer the potential for high returns but also carry a high level of risk. Bonds are loans made to companies or governments. They offer lower returns than stocks but also carry less risk. Cash and cash equivalents are the safest investments but offer the lowest returns.
Stocks
Stocks represent ownership in a company. When you buy a stock, you become a shareholder, which means you own a piece of the company. Stocks offer the potential for high returns but also carry a high level of risk. The value of a stock can go up or down, depending on a variety of factors, including the company's financial health and the overall health of the economy.
There are two main types of stocks: common stocks and preferred stocks. Common stocks give shareholders the right to vote at shareholder meetings and to receive dividends. Preferred stocks give shareholders a higher claim on the company's earnings and assets than common shareholders, but they do not have voting rights.
Bonds
Bonds are loans made to companies or governments. When you buy a bond, you are lending money to the issuer in exchange for regular interest payments and the return of the principal when the bond matures. Bonds are generally considered less risky than stocks, but they also offer lower returns.
There are several types of bonds, including corporate bonds, government bonds, and municipal bonds. Corporate bonds are issued by companies. Government bonds are issued by the federal government, and municipal bonds are issued by provinces (Ontario Savings Bonds) and municipalities.
Cash and Cash Equivalents
Cash and cash equivalents are the safest investments but offer the lowest returns. These include money market funds, Treasury bills, and Guaranteed Investment Certificates (GICs). These investments are considered liquid, which means they can be easily converted into cash (except non-cashable GICs which typically have a a 1-year locked-in term).
While these investments offer the lowest returns, they also carry the lowest level of risk. This makes them a good choice for investors who are risk-averse or who need to keep some of their portfolio in a liquid form.
portfolio asset allocation
Strategies for Asset Allocation
There are several strategies for asset allocation. These include strategic asset allocation, tactical asset allocation, and dynamic asset allocation. Each of these strategies has its own advantages and disadvantages.
Strategic asset allocation involves setting target allocations for various asset classes, and periodically rebalancing the portfolio back to those targets as investment returns skew the original asset allocation percentages. The portfolio is rebalanced to the original allocations when they deviate significantly from the initial settings due to differing returns from various assets.
Strategic Asset Allocation
Strategic asset allocation is a strategy that involves setting target allocations for various asset classes, and then periodically rebalancing the portfolio back to those targets as investment returns skew the original asset allocation percentages. This strategy is based on the belief that the markets are efficient and that it's not possible to consistently outperform the market through active management.
The main advantage of strategic asset allocation is that it's simple and easy to understand. It also requires less time and effort than other strategies because you're not constantly trying to time the market. The main disadvantage is that it doesn't take into account changes in the market or in your financial situation.
Tactical Asset Allocation
Tactical asset allocation is a more active strategy that involves adjusting your portfolio's asset allocation based on short-term market predictions. This strategy requires a more hands-on approach and a higher level of investment knowledge and experience.
The main advantage of tactical asset allocation is that it can potentially generate higher returns if your predictions are correct. However, this strategy also carries a higher level of risk because it's based on the assumption that you can accurately predict the future direction of the market.
Dynamic Asset Allocation
Dynamic asset allocation is a strategy that involves adjusting your portfolio's asset allocation based on the current state of the economy. This strategy requires a deep understanding of economic indicators and how they can affect various asset classes.
The main advantage of dynamic asset allocation is that it can potentially generate higher returns during periods of economic growth. However, it also carries a higher level of risk because it's based on the assumption that you can accurately predict the future state of the economy.
Implementing Asset Allocation
Implementing asset allocation involves determining your investment goals, risk tolerance, and time horizon. Once you've determined these factors, you can choose an asset allocation strategy and start building your portfolio.
It's important to remember that asset allocation is not a one-time decision. You should regularly review and adjust your asset allocation as your financial situation changes. This could be due to changes in your financial goals, risk tolerance, or time horizon.
Choosing an Asset Allocation Strategy
Choosing an asset allocation strategy involves determining your investment goals, risk tolerance, and time horizon. Your investment goals are what you hope to achieve with your investments. This could be saving for retirement, paying for a child's education, or buying a home.
Your risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. Your time horizon is the length of time that you expect to hold your investments. If you have a long time horizon, you may be able to take on more risk because you have more time to recover from any losses.
Building Your Portfolio
Once you've chosen an asset allocation strategy, you can start building your portfolio. This involves choosing investments that match your asset allocation strategy. For example, if your strategy calls for 60% stocks and 40% bonds, you would choose investments that fit these categories.
It's important to diversify your portfolio by investing in a variety of different assets. This can help reduce risk and increase potential returns. For example, if one asset performs poorly, it may be offset by another asset that performs well. A financial advisor can help you maximize your wealth by allocating your portfolio strategically.
Reviewing and Adjusting Your Asset Allocation
Asset allocation is not a one-time decision. You should regularly review and adjust your asset allocation as your financial situation changes. This could be due to changes in your financial goals, risk tolerance, or time horizon.
If your financial situation changes significantly, you may need to adjust your asset allocation. For example, if you get a new job with a higher salary, you may be able to take on more risk. Or, if you're getting closer to retirement, you may want to shift more of your portfolio into safer investments or guaranteed income options like an annuity.
Asset Allocation: Conclusion
Asset allocation is a fundamental concept in investing. It involves dividing your portfolio among different asset classes to manage risk and increase potential returns. The right asset allocation for you depends on your investment goals, risk tolerance, and time horizon.
There are several strategies for asset allocation, including strategic asset allocation, tactical asset allocation, and dynamic asset allocation. Each of these strategies has its own advantages and disadvantages. It's important to choose a strategy that fits your financial situation and investment goals.
Once you've chosen an asset allocation strategy, you can start building your portfolio. Remember to regularly review and adjust your asset allocation as your financial situation changes. This can help you stay on track with your investment goals and manage risk.