How Does Asset Allocation Work?
Even the most planned out investments can fail if you don’t allocate your assets across a variety of categories. In other words, you must spread out your money over a variety of investments. It’s called asset allocation, and when you do it right, you could fend off the risk of a total loss.
Knowing how it works and what you must understand is important before you start investing. If you jump in headfirst and invest in the assets that sound good to you, your portfolio may leave you rather disappointed.
Asset Allocation Defined
Asset allocation is the practice of spreading your money across a variety of assets and asset categories. For example, if you put all your money in stocks, you’re at the mercy of the stock market. If it crashes, you could lose everything.
The same is true if you invested all your money in bonds, mutual funds, or ETFs. Concentrating all your money on one asset is risky.
If, instead, you diversified amongst a variety of investments, such as stocks, bonds, commodities, and even property, you diversify your risk. If the stock market crashed and you lost everything invested in stocks, you’d still have money in bonds, commodities, and possibly property.
How Asset Allocation Works
Asset allocation helps diversify your money across a variety of assets. The key is to choose assets with different traits, aka risks and rewards. Look at each asset and determine how it would respond to the economy failing and thriving. Some will move with the economy, and some assets will move in the opposite direction.
When you have a mixture of assets moving in different directions, you’re better off in the end. Each class has different reactions, so to speak, so your portfolio stays somewhat steady even though the investments in it may go up and down. When one goes up, another may go down and vice versa.
The idea is to create a non-volatile portfolio or a portfolio that achieves the returns you desire without risking too much on any one investment. It’s the old adage ‘don’t put all your eggs in one basket,’ if you need a visual to see how it works.
Every investor has a different portfolio because each investor has different needs. One may be saving for retirement and have 30 years, while another may be investing for another shorter-term purpose, such as buying a house.
Investors with shorter-term goals can take fewer risks and need an asset allocation with a lower risk than an investor who has 30 years to let his/her portfolio grow.
What are the Most Common Asset Classes?
You have many options when choosing your asset classes. As always, it’s best to diversify as much as possible, but working with a licensed advisor can help you determine which assets are right for you based on your timeline and your goals.
Here are the most common asset classes:
- Cash – While it’s not an investment, every portfolio should have some cash value. You can keep it in a savings account, CD, or any other liquid account. No matter where you keep it, your rate of return will be minimal, but you’ll have the stability of having a portfolio with at least some cash value.
- Bonds – If you want a ‘safe’ investment, bonds are usually a good choice. It depends on who issues the bonds, but you usually receive a fixed rate of interest that you can receive either monthly, quarterly, annually, or at maturity. Government bonds are the least risky but pay the lowest interest rates.
- Stocks – When you invest in stocks, you buy a portion of a company. Your returns are based on how the company performs. You can buy and sell stocks at any time, paying capital gains on your profits. Stocks have a higher risk than most other investments but also provide the highest return.
- Commodities – Gold, oil, and agricultural products, all makeup commodities. You trade futures or the right to buy or sell the product at some point. Commodities are risky but can diversify a portfolio, especially one that’s heavy in stocks.
- Property – You can invest in physical property, such as an investment home, or in property investment trusts which are pooled funds that you and other investors create. The fund manager uses the funds to help property investors buy commercial properties or even invests in property debt (mortgage).
What Should your Asset Allocation Be?
Now that you know you should diversify your investments, what should your asset allocation be? While no two investors have the same needs, consider the following:
- What are your investment goals? Your investment goals are the primary determining factor in the investments you choose. How much money do you need, and what are you trying to achieve? Write your goals down, as they’ll help you choose the investments that are right for you and your family.
- How much time do you have? Your time horizon is the next most important factor. If your goals are long-term, you have more time to make up for any potential losses and take larger risks. You may invest more heavily in stocks and property than you would in bonds or cash investments.
- How old are you? Age is another way to look at your time horizon. If you’re investing in your child’s college education, and your child is 2 years old, you have a longer time to save. But if your child is 12 years old, you have less time and may want less aggressive investments. The same principle applies to retirement; the older you are when you invest, the less time you have to reach your retirement goals.
- What is your risk tolerance? Think about what you can stand to lose. No one wants a complete loss or any loss for that matter, but what can you stomach? Will you sleep at night knowing you may have a total loss, or would it be too disturbing? This helps to determine the right asset allocation.
Is Asset Allocation Different from Diversification?
Asset allocation and diversification have some similarities, but they are two different concepts. Asset allocation refers to how you spread your money across the many asset categories. For example, if you invest in stocks, bonds, and property, that’s your asset allocation or the money you invest in each asset.
Diversification refers to how you diversify your investments within each category. For example, you could invest in stocks, but do you want to put all your money in one stock? What if it plummets? What happens? You’d likely lose everything.
If, instead, you diversified your funds throughout several stocks – preferably stocks in different industries, or even in an ETF that mimics the S&P 500, you’d be better off.
Do you Need to Change your Asset Allocation?
Like most things in life, your asset allocation may need to change. If life changes, you may have other goals or need to adjust your investments.
Most people change their asset allocation with age – the closer they get to their goal timeline, the less aggressive they want to invest. The less time you have available, the less risk you can take. What would happen if you lost it all? You’d enter your timeline with nothing. If you adjust your allocation, you could still have money because you invested in safer investments.
What About Rebalancing?
Rebalancing your portfolio is important too. As time goes on, your investments change in value and may knock your allocation off course.
Rebalancing puts everything back into the balance you chose when you created your portfolio. For example, if the stock market takes off, your portfolio may become more stock-heavy than bond-heavy than you’d prefer. We could sell off some of the stock gains and buy more bonds, resetting your asset allocation.
If you don’t want to sell off investments that are doing well, you could also invest more money into the bonds or any other asset that your portfolio has an incorrect balance.
Asset allocation and diversification are the keys to a properly created portfolio. It takes time, practice, and knowledge to create the right portfolio for you and your family.
It doesn’t matter if you have short-term goals that you want to reach in the next year or long-term goals that go out as far as 30 years; allocating your assets appropriately will help you reach your goals.