Asset Allocation

1. Goal factors

Goal factors are individual aspirations to achieve a given level of return or saving for a particular reason or desire. Therefore, different goals affect how a person invests and risks.

2. Risk tolerance

Risk tolerance refers to how much an individual is willing and able to lose a given amount of their original investment in anticipation of getting a higher return in the future. For example, risk-averse investors withhold their portfolio in favor of more secure assets. In contrast, more aggressive investors risk most of their investments in anticipation of higher returns. Learn more about risk and return.

3. Time horizon

The time horizon factor depends on the duration an investor is going to invest. Most of the time, it depends on the goal of the investment. Similarly, different time horizons entail different risk tolerance.

For example, a long-term investment strategy may prompt an investor to invest in a more volatile or higher risk portfolio since the dynamics of the economy are uncertain and may change in favor of the investor. However, investors with short-term goals may not invest in riskier portfolios.

How Asset Allocation Works

Financial advisors usually advise that to reduce the level of volatility of portfolios, investors must diversify their investment into various asset classes. Such basic reasoning is what makes asset allocation popular in portfolio management because different asset classes will always provide different returns. Thus, investors will receive a shield to guard against the deterioration of their investments.

Example of Asset Allocation

Let’s say Joe is in the process of creating a financial plan for his retirement. Therefore, he wants to invest his $10,000 saving for a time horizon of five years. So, his financial advisor may advise Joe to diversify his portfolio across the three major categories at a mix of 50/40/10 among stocks, bonds, and cash. His portfolio may look like below:

• Stocks
  • Small-Cap Growth Stocks – 25%
  • Large-Cap Value Stocks – 15%
  • International stocks – 10%
• Bonds
  • Government bonds – 15%
  • High yield bonds – 25%
• Cash
  • Money market – 10%

The distribution of his investment across the three broad categories, therefore, may look like this: $5,000/$4,000/$1,000.

Strategies for Asset Allocation

In asset allocation, there is no fixed rule on how an investor may invest and each financial advisor follows a different approach. The following are the top two strategies used to influence investment decisions.