Asset allocation refers to how you invest your funds across different asset classes such as stocks, bonds and cash or cash equivalents. Your asset allocation typically depends on your investment goals, financial circumstances and risk tolerance.
Asset allocation is vitally important as it allows you to maximize returns while satisfying investment goals.
Risk
Your investment portfolio’s risk depends on how much of your money is distributed among each asset class. That is why most brokerage firms and financial services companies provide asset allocation models that help you determine how much should go toward stocks, bonds and cash or cash equivalent investments.
Experts typically recommend selecting an asset allocation that reflects both your time horizon and risk tolerance. Investors with longer time horizons may feel comfortable taking more risks and opt for more aggressive, high-risk portfolios.
However, asset allocation’s risk can fluctuate with time as different assets experience different rates of growth or decline. For instance, investing heavily in stocks when the stock market goes south can cause greater volatility and financial loss; with well-diversified holdings you are less likely to incur substantial financial loss as time goes on; to prevent this happening frequently rebalance your portfolio to ensure long-term success.
Return
Asset allocation is one of the key elements to consider when building an investment portfolio. Proper allocation helps investors reduce market volatility and provide more flexibility when liquidating assets to generate cash; since not all asset classes move together; investing in stocks, bonds and cash provides diversification benefits.
Your asset allocation in your portfolio depends on your investment goals, risk tolerance, and time horizon. For instance, if you are saving for retirement, bonds and cash equivalents might be more suitable because this reduces risk in the short-term as you near your investment goal.
Discover an asset allocation that best matches your risk profile by filling out free online questionnaires available on various websites, such as those maintained by investment publications, mutual fund companies, and financial professionals.
Time horizon
Time horizon is one of the key determinants in asset allocation decisions, which means how long until you need the money from your investments back. The longer your time horizon, the greater the risks you can take with your portfolio. A couple of rough years won’t hurt as much if there are decades until you need your investments back!
Your time horizon can also fluctuate with life events and changing circumstances, so if you’re saving for college tuition for one of your children, your timeline could be shorter than someone already retired.
If your short-term investment horizon is limited, liquid investments such as cash and savings accounts may help minimize volatility and protect against large losses. On the other hand, for long-term investors seeking higher returns over time it is crucial that their portfolio includes growth-oriented stocks and exchange-traded funds (ETFs).
Rebalancing
Rebalancing strategies aim to bring your portfolio back in line with its original asset allocation plan. For instance, let’s say you started off with a 60/40 split between stocks and bonds but over time the former outperformed the latter, leading your stock percentages to shift upward. In such an instance, in order to restore balance to your initial 60/40 allocation you may have to sell some stocks and purchase additional bonds so as to achieve balance again.
Rebalancing can be an effective strategy to lower risk in a portfolio while increasing return potential. Different investments tend to move in opposing directions, helping you hedge against market volatility by decreasing exposure to risk.
Rebalancing also enables you to take advantage of market opportunities, like buying low during a downturn, which may help you achieve your financial goals more quickly and reduce the costs and taxes associated with frequent trading which could reduce returns over time.