What Is Asset Allocation?

Daniel Penzing
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Read on for examples and guidelines on asset allocation.

Numerically, asset allocation is the division of investment assets into categories of risk. By investing in each of these categories, an investor is spread out protection against a downtrend in any one category. For example, if an investor was to put all his money into a real estate investment that was subsequently devalued by the loss of a major tenant, he may lose a substantial portion of his investment. However, if he had also invested in a bond-based investment in the same amount of money, his overall portfolio would have been protected due to diversification into a different asset category.

By diversifying, one reduces internal risk, while also gaining protection, however small, against external risks. For instance, if an investor wanted to reduce exposure to real estate, he could spread his eggs across the various asset categories, and trade in real estate as the opportunity arose in order to reduce overall risk of a dip in values.

My Own Asset Allocation for Retirement

Asset allocation is the approach many investors take to spread their money into different assets classes (for example, cash, bonds, and stocks) in the belief that these allocations will make them more secure and behave differently in different economic climates.

For investors, one of the most important things to understand about asset allocation is that diversification is the key. Diversification means spreading your investments around so that you are not overexposed to a single asset class, industry, sector, or geographic region. This means that as one area of the market is struggling, another area is thriving.

A diversified portfolio will usually include assets such as stocks, bonds, cash, real estate, commodities, and so on. In this way, you can expect to see some ups and some downs in your portfolio (this is normal and expected) but the ups will usually offset the downs.

The easiest way to diversify your portfolio is to diversify into multiple asset classes, but there are also ways to diversify within each asset class. Most analysts combine three to five different asset classes in their portfolio (e.g. stocks, bonds, real estate, commodities, precious metals, etc). Some will divide their portfolio equally between a handful of asset classes and others will diversify across the spectrum. The trick is to understand the landscape, and go in with a plan.

High Level Asset Allocation

Asset allocation is a way to manage investment risk. The general investment rule is that you should invest in a portfolio of assets that have a lower correlation with each other.

What this means is that there are degrees of risk associated with different asset classes. Some assets carry more risk than others and will experience larger increases and larger decreases in value as a result. And different assets will have different degrees of risk.

More risky assets are good for investors who are willing and able to accept greater risk (and the potential for greater gains). Less risky assets are good for investors who are not as willing or able to accept greater risk (and the potential for greater gains).

The asset allocation that you end up choosing takes both your appetite for risk and your financial circumstances into account. The idea is that there is no such thing as a risk free investment, so you want to be certain that your investments are appropriate for you, and that they reflect both your appetite for risk and your ability to take risk.

Stock Allocation

The portfolio forming process, the asset allocation section, is vital to determining the overall risk of a portfolio of assets. The asset allocation portion is made-up of about 80% of the portfolio's total risk. The remaining 15% of the risk involved is held by the securities within a portfolio.

Asset allocation plays a large part in determining the overall risk of a portfolio. Asset allocation is the determination of what percentage of a portfolio's assets is to be invested in equity, fixed-income, cash or other asset classes. This portion of the process helps to determine all of a portfolio's risk and is more of a financial planning process, rather than a strict mathematical formula. This important part of the investing strategy must be done with the goal of obtaining the highest return for a specific level of risk.

One of the main questions for a particular investor is to establish how much risk he/she is willing to take. The relationship between return and risk is represented by the capital asset pricing model. Also, asset allocation depends on an investor's investment objectives. Specifically, asset allocation considers what time frame (long or short) and risk level is acceptable to an investor.

Bond Allocation

In an overall portfolio of investments, no asset class will control how the portfolio performs in years to come. But that's not to say we don't try. Through strategic asset allocation, we try to reduce investment risk by allocating more money to what we consider "lower risk" investments.

Typically, bonds are considered to be less risky than stocks because they provide a steady stream of income, and so they will often be assigned a higher weighting in a portfolio than stocks.

In 2017, bonds were deemed to be "risk-off" investments as interest rates rose, and investors rushed to the safety of U.S. government bonds. Like investors, bond funds are also tacking on a premium of late as spreads have widened. This makes investing in bond funds less attractive compared to holding the bond directly.

Single-Bond Weighting

Another consideration is whether you want to allocate to a single bond or a mutual fund. Bond funds can offer more diversity and can help you with a bond allocation, compared to a single bond, and its allocation will depend on several factors. For example, if you are young, are looking to maximize income, and are willing to take on more risk, then a bond fund may be a good fit for you.

As you get older or if you are in a lower tax bracket, then a lower-risk bond fund may be a good choice.

Commodity Allocation

One of the most popular forms of asset allocation is called the Commodity Allocation strategy.

It’s the mother of all allocation strategies, so to speak.

Asset allocation was developed in the late 1970s and early 1980s. In the mid-1970s, the U.S. economy faced three huge challenges:

  • The Oil Price Shock (¥¬£14 / Barrel)
  • The Recession in the United States (4 quarters of negative GDP growth)
  • A Changing Political Climate

Each of these events demanded more than simple intervention from the U.S. government. It demanded significant changes in the way that the market interacted, and it demanded that the market change the way that it performed.

Asset Allocation was developed as a way to control risk. Asset allocation is designed to reduce the impact of issues that arise from large changes in the market in one regard or another.

Any negative changes in one economy, like the United States, will have an impact on the world as a whole. Changes in one part of the market can spread like a virus and cause a ripple effect throughout the rest of the market.

Real Estate Allocation

Vs. Retirement Allocation

Different parts of your portfolio should be put in to different types of investments.

For example, you might choose to invest in:

Retirement: This would be an allocation that you have for your future in a 401k or a similar retirement account.

Cash: This would be money you have in a bank account that you are planning to use daily, weekly, or monthly.

Stocks: This would be an allocation that you have to invest in stocks that are going to be in growth for long term profits.

Bonds: This would be an allocation that you have to invest in bonds for long term profits.

Property: This would be an allocation you have to invest into property or real estate.

These are a few different allocations, but they are not the only ones that you can create. You can also set up your own allocation so that you get a profitable return on your investment.

To learn how to get the most out of asset allocation, you might want to consider a financial advisor that can help you out.

Cash

Stocks and Bonds.

Let’s start with a simplistic definition, and then examine some of the underpinnings of this definition. A mutual fund is a collection of securities that is invested in a methodical and pre-determined manner. For simplicity, we’ll ignore the fact that a mutual fund itself can be categorized into no more than a few broad types, such as: growth, value, large, small, large value, small growth, international, etc. (There are hundreds, if not thousands of mutual funds out there!)

A stock is a single share (in a company), and a "stock market" is a collection of all the shares in the company.

A bond is an article of indebtedness that is issued by a corporation or city to finance some capital project. The corporation or city in exchange for money agrees to pay a specified interest rate (i.e. a coupon) and to pay the money back (with interest) at a date in the future.

Rebalancing Rules

When it comes to investing, risk management is rated as the number one priority. While this may seem like an easy task in theory, risk management can be very difficult in implementation. This is because psychology often gets in the way. As investors, we are wired to remember potential gains and losses rather than their probabilities. In our minds, large losses outweigh small gains even though the mathematics does not support this reality. When it comes to investing, the most effective way to manage and control risk is by diversification. Over the long run, an investor’s risk is directly related to the percentage of investments in the portfolio they hold. The more assets an investor holds, the greater the smoothing of performance in any one asset class. The flip side of this logic is to know that the greater the diversity in a portfolio, the lower the returns will be.

Back to understanding risk management, diversification is the math of risk. These are averages which will apply to most investors in most markets, but they can vary widely and they won’t tell you anything about what you should do or how you should invest. This is where asset allocation comes into play. Asset allocation is a way you can control the degree of risk by choosing where to invest your assets. Then you can manage that risk by how you hold your assets.

Can You DIY?

Asset allocation (AA) is the process of dividing your investment money into different asset classes. In the simplest terms, each class represents a particular asset class such as stocks, bonds, and cash. Of course, this is a very simple way to think about AA, and it’s not as cut-and-dry as that. But for our purposes, it’ll work for now. The theory behind AA is that you should divide your money into several pieces or “pieces of the pie.” You should put some of your money into stocks, some into bonds, some into cash, and some into real estate. Because each of these investments is tied to a different asset class, you should get different results over the long term. Although there are exceptions, most of the time one class will perform better than the others.

What Types of Assets Can You Choose From?

As we mentioned before, the process of asset allocation is quite simple; you just need to divide your investments into different categories that cater to your risk tolerance, goals, and time horizon.

In general, there are three classes or types of investment assets:

☆Cash assets (e.g. cash, money market instruments)

☆Lending or secure assets (e.g. bonds, bonds, annuities, certificates of deposit)

☆Risky or speculative assets (e.g. stocks, real estate investment trust, bullion, commodity, real estate, futures and options, funds)

The assets of the most risk are generally at the top of the pyramid, while the safest assets are at the bottom.

For example, most financial advisers will advise you to allocate at least 20% to 25% of your portfolio in cash assets. In other words, as a general rule, you should keep at least 25% in cash, and the remaining 75% should be invested in other assets that have a higher risk.

A Few Factors to Consider

Asset allocation, simply put, is how money is distributed throughout different asset sub-classes. It typically falls into five main categories: cash, fixed income, equity, real estate, and commodity. However one must consider many factors when making their ultimate asset allocation as it is important to diversify not just from sector to sector but across both long and short term investments. Another factor to consider is that asset allocations can change over time as market conditions shift.

Things to consider when reviewing your asset allocation are as follows: