The term, Asset Allocation is used often in the financial world but what does it exactly mean? First, you must understand that you will have an asset allocation within an investment portfolio/account. This investment portfolio/account will have money you saved and set aside for a specific financial goal, whether that goal is saving to purchase a home, college funding or most commonly for your retirement. You may already have an investment portfolio if you are contributing to a 401k plan.
Asset Allocation is an investment strategy that involves different asset categories, such as cash, equities and fixed income. The mixture of these asset categories will assist in managing the risk and performance of an investment portfolio. This is important because the asset allocation will have an impact on meeting your financial goal you established. I have outlined some points below that you will need to decide in order to select your asset allocation.
When do you need to begin using the money in the portfolio? This is known as a time horizon. If the money is not to be used for a long time typically longer than 10 years then the portfolio may be able to take on riskier asset categories and handle market volatility. In contrast, if the time horizon is less than 5 years, less risky asset categories should be considered.
What is your risk tolerance for this money? Each asset category has a level of risk associated with it and every person has a different risk tolerance level. You will need to determine how much risk you are willing to take to increase your portfolio’s performance. Riskier assets provide growth or the potential to increase your portfolio value, while experiencing some volatility along the way. Less risky assets may just provide you with some income but no growth. This is a more conservative approach.
Fact: 91.5% of your portfolio’s return (performance) comes from asset allocation!
Asset categories mentioned above, cash, equities and fixed income are the most common and each has their own level of risk. Cash has the least amount of risk while fixed income has some risk but much less volatile and typically produces income like a Certificate of Deposit. Equities hold the trophy for being the riskiest and most volatile asset. Remember, the higher the risk the more potential for growth/performance. Once you determine your time horizon and risk tolerance then choosing how much you should have in each asset category is next step. These three asset categories typically do not move in the same direction therefore a portfolio can protect itself against major movements, either in losses or gains, by choosing an asset allocation that contains all three.
For an example: I have a friend who is 35 years old and has a portfolio she contributes to every month towards her retirement, which is at least 25 years away. My friend’s time horizon is longer than 10 years. What should her risk tolerance be? This can only be determined by my friend as she has to be comfortable with her decision. She feels that because she has a long term horizon she should be invested for Growth but also wants some comfort of conservativeness. Her asset allocation is 65% equities and 30% fixed income with 5% cash. However, the same aged person may not want any equities and have a 100% fixed income asset allocation for their portfolio. That too is fine, because it is what works for them. The difference between the two allocations may mean that one will meet their goal and the other may not. Equities provide the growth in a portfolio while fixed income only provides income earned but no growth.
Now, there are two more steps to be discussed and they are Diversification and Rebalancing. I will discuss both steps in my next blog. Stay tuned and……
>Good Luck and know what you are invested in.