Think of it as the inverse of putting all your eggs in one basket. Allocating your investments across asset classes is an important strategy for reducing risk and potentially increasing returns.
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| The Best Way to Allocate Your Assets |
How Does Asset Allocation Work?
Spreading your investments across different asset classes is what asset allocation entails. That generally refers to a combination of securities from the cash or money market, bonds, and stocks.
There are subclasses within each of these three classes:
- Shares issued by companies with a market capitalization greater than $10 billion are classified as large-cap stocks.
- Mid-cap stocks are those issued by companies with a market capitalization ranging from $2 billion to $10 billion.
- Companies with a market capitalization of less than $2 billion are classified as small-cap stocks. Because of their lower liquidity, these equities are riskier.
- Any security issued by a foreign company and listed on a foreign exchange is considered international security.
- Securities issued by businesses in developing countries are known as emerging markets. Because of the possibility of country risk and lower liquidity, these investments have a high potential return but also a high risk.
- Repaired securities are highly rated corporate or government bonds that pay a set amount of interest to the holder on a regular or periodic basis and return the principal at the end of the period. These securities are less volatile and risky than stocks.
- Investing in debt with a maturity of one year or less is known as the money market. T-bills are the most common type of money market investment.
- REITs are shares in an investor pool of mortgages or properties.
Optimizing Return and Risk
In order to meet your desired level of return while minimizing risk, your assets should be allocated. To accomplish this, you must understand the risk-return characteristics of the various asset classes. The chart below compares some of them in terms of risk and potential return:
The highest potential return but also the highest risk investment is equity. Treasury bills have the lowest risk because they are guaranteed by the United States government, but they also have the lowest income.
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| The Best Way to Allocate Your Assets |
It's the risk-return tradeoff. High-risk investments are better suited to investors with higher risk tolerance. That is, they can tolerate large swings in market prices. An investor who is younger and has a long-term investment account can anticipate a recovery. A couple nearing or in retirement may not want to jeopardize their accumulated wealth.
The general rule is that an investor should gradually cut back on risk exposure over time in order to retire with a respectable sum of money stashed away in secure investments.
For this reason, asset allocation-based diversification is crucial. Every investment has its own set of risks and market fluctuations. Your entire portfolio is protected from the ups and downs of a single stock or class of securities by asset allocation.
As a result, while a portion of your portfolio may be made up of riskier securities that you chose because they have the potential to yield higher returns, the remainder of your portfolio is made up of more reliable investments.
Choosing What Is Best for You
Investors should base their asset composition on their risk tolerance, investment objectives, time horizon, and available funds because each asset class has a unique level of return and risk. All of this is critical as investors seek to build their ideal portfolio.
High-risk, high-return options may be appealing to investors with a long time horizon and larger sums to invest. Low-risk, low-return allocations may be preferred by investors with smaller sums and shorter time horizons.
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| The Best Way to Allocate Your Assets |
Many investment firms create a series of model portfolios, each with a different proportion of asset classes, to make the asset allocation process easier for clients. Each portfolio caters to a specific level of investor risk tolerance. These model portfolios range from conservative to very aggressive in general.
A Moderate Portfolio
Large portions of the total are typically allocated to lower-risk securities, such as fixed-income and money market securities, in conservative model portfolios.
The primary goal of a conservative portfolio is to protect your portfolio's principal value. As a result, these models are frequently referred to as capital preservation portfolios.
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| The Best Way to Allocate Your Assets |
Sometimes if you are extremely conservative and would prefer to avoid the stock market entirely, some stock exposure can help offset inflation. The equity portion can be placed in an index fund or a high-caliber blue-chip company.
A Portfolio That Is Moderately Conservative
For the investor who wants to preserve the majority of the portfolio's total value but is prepared to assume some risk in exchange for inflation protection, a moderately conservative portfolio works. Current income is a common strategy within this risk level. Using this strategy, you select securities that offer a high dividend or coupon yields.
A Portfolio That Is Moderately Aggressive
Because the asset composition is almost evenly divided between fixed-income securities and equities, moderately aggressive model portfolios are often referred to as balanced portfolios. The balance is between income and growth. This strategy works best for investors with a longer time horizon (typically more than five years) and a medium level of risk tolerance because moderately aggressive portfolios have a higher level of risk than conservative portfolios.
A Portfolio That Is Aggressive
Because aggressive portfolios are primarily comprised of equities, their value can fluctuate greatly from day to day. If you have an aggressive portfolio, your primary goal is to achieve long-term capital growth. An aggressive portfolio strategy is also known as a capital growth strategy. Investors with aggressive portfolios typically include some fixed-income securities to provide diversification.
A Portfolio That Is Extremely Aggressive
Extremely aggressive portfolios are almost entirely comprised of stocks. The goal of a very aggressive portfolio is strong capital growth over a long time horizon. The value of these portfolios will fluctuate greatly in the short term due to the high level of risk involved.
Customize Your Allocations
Only a broad generalization can be provided by these model portfolios and the corresponding strategies. You can change the proportions to meet your specific investment needs. Your future capital needs and your style of investing will determine how you adjust the models above.
For example, if you enjoy researching your own companies and devoting time to stock picking, you will most likely further divide the equities portion of your portfolio into stock subclasses. You can achieve a specialized risk-return potential within one portion of your portfolio by doing so.
Furthermore, the percentage of your portfolio allocated to cash and money market instruments will be determined by the amount of liquidity and safety required.
You might think about investing more of your investment portfolio in short-term fixed-income securities or money markets if you need investments that you can quickly liquidate or if you want to keep your portfolio's current value.
A smaller percentage of an investor's portfolio will consist of these instruments if they have a higher risk tolerance and no worries about liquidity.
Keeping Your Portfolio Alive
You may choose one of several basic allocation strategies when deciding how to allocate your portfolio. Each provides a unique approach based on the investor's time frame, objectives, and tolerance for risk.
Once your portfolio is operational, it's crucial to periodically review it. This includes taking into account how your life and financial needs have changed. Consider whether it's time to adjust your asset weighting.
You might discover that your portfolio needs to be rebalanced even if your priorities haven't changed. That is, you might transfer some of the profit from a moderately aggressive portfolio into safer money market investments if it recently generated a lot of gains from stocks.
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| The Best Way to Allocate Your Assets |
A fundamental investing principle called asset allocation enables investors to maximize gains while lowering risk. The various asset allocation strategies that were just discussed accommodate a variety of investment styles as well as different risk appetites, time horizons, and objectives.
Remember to periodically review your portfolio once you've settled on an asset allocation strategy that works for you to make sure you're maintaining the intended allocation and staying on course for your long-term investment objectives.
