What is Asset Allocation

Asset allocation is all about how you spread your investments across different types of assets. The idea is to mix things up to help reduce the risks that come with investing. There are three major categories of asset classes: equities, fixed-income, and cash and equivalents.

Anything that doesn't fit into these three categories, which include real estate, commodities, or art, is usually referred to as alternative assets.

Synonyms

• Asset distribution
• Resource allocation
• Portfolio distribution

Types of Assets Strategies

1. Strategic Asset Allocation

The strategic asset allocation approach involves creating and adhering to a base policy that can be balanced with different assets. Examples are stocks and bonds, which are based on their expected returns.

When setting up a strategic asset allocation, you need to consider your risk tolerance and how long you are planning to invest. Once you have set your targets, you will need to rebalance your portfolio to stay on track.

2. Tactical Asset Allocation

Tactical asset allocation is like taking a more moderate approach to managing your investments. You will need to adjust your portfolio to capitalize on short-term opportunities. However, once you’ve achieved those quick gains you can return to your original long-term strategy.

This type of approach requires a good sense of timing and discipline. It is important to know when it is time to move back to your long-term plan after seizing short-term gains. All this is about striking a balance between taking advantage of immediate opportunities and staying true to your long-term investment goals.

3. Constant-Weighting Asset Allocation

Strategic asset allocation usually means sticking with a buy-and-hold approach, even if the value of your investments starts to move away from your original plan. However, some people might prefer a more hands-on-hands method which is called constant-weighting asset allocation.

This type of approach involves regularly rebalancing your portfolio to maintain your desired asset. For example, if one of your investments drops in value, you might need to buy more of it to keep this proportion of your portfolio steady.

On the other hand, if your investment’s value goes up, you might need to sell some of it to prevent it from taking up too much of your portfolio. This way, you’re always fine-tuning your investments to stay aligned with your goals.

Factors Affecting Asset Allocation Decision

When deciding on how to invest, there are some factors you need to look out for. Such as your personal goals, your level of risk tolerance, and how long you plan to invest. All this plays a big role in improving your portfolio. Some of these factors are:

1. Goal factors

Goal factors are one’s personal aspirations, whether there is a given level of return or saving. These goals are directly influenced by how you invest and the risks you are willing to take.

2. Risk tolerance

Risk tolerance is all about understanding how much of your investment you are willing to risk with the hope of earning a higher return in the future. If you are risk-averse, you’ll need to stick to safer investments that offer steady but lower returns. But, if you are more aggressive, you are most likely to take bigger risks with your money.

3. Time horizon

The time horizon means the length of time you plan to keep your money invested, which often aligns with your investment goals. Your risk tolerance can shift depending on how long you are planning to invest. 

For instance, if you are in it for the long term, you might be willing to take on a riskier investment. With a more volatile portfolio, you have time for the ups and downs of the market.

Example of Asset Allocation

Let’s say Peter is in the process of creating a financial plan for his retirement. Therefore, he wants to invest his $20,000 savings for a time horizon of four years. However, his financial advisor has advised Peter to diversify his portfolio across the three major categories at a mix of 50/30/20 among stocks, bonds, and cash. This is how his portfolio will look like below:

• Stocks

Large-Cap Value Stocks – 15%

Small-Cap Growth Stocks – 25%

International stocks – 10%

• Bonds

Government bonds – 15%

High yield bonds – 15%

• Cash

Money market – 20%

So, if Peter can follow this plan, his $20,000 would be distributed like this: $10,000 in stocks, $6,000 in bonds, and $4,000 in cash. This diversified approach will help Peter manage risk while aiming for growth as he heads towards retirement.