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THINGS TO KNOW ABOUT ASSET ALLOCATION 3. Determine Your Long- and Short-Term Goals We all have our goals. Whether you aspire to build a fat retirement fund, own a yacht or vacation home, pay for your child's education or simply save for a new car, you should consider it in your asset-allocation plan. All these goals need to be considered when determining the right mix. For example, if you're planning to own a retirement condo on the beach in 20 years, you don't have to worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments. And as you approach retirement, you may want to shift to a higher proportion of fixed income investments to equity holdings. 4. Time Is Your Best Friend The Department of Labor has said that for every ten years you delay saving for retirement (or some other long-term goal), you will have to save three times as much each month to catch up. Having time not only allows you to take advantage of compounding and the time value for money, it also means you can put more of your portfolio into higher risk/return investments, namely stocks. A couple of bad years in the stock market will likely show up as nothing more than some insignificant blip 30 years from now. 5. Just Do It! Once you've determined the right mix of stocks, bonds and other investments, it's time to implement it. The first step is to find out how your current portfolio breaks down. It's fairly straightforward to see the percentage of assets in stocks versus bonds, but don't forget to categorize what type of stocks you own (small, mid or large cap). You should also categorize your bonds according to their maturity (short, mid or long term). Mutual funds can be more problematic. Fund names don't always tell the entire story. You have to dig deeper in the prospectus to figure out where fund assets are invested. The Bottom Line There is no single solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you don't have, don't worry. It's never too late to get started. It's also never too late to give your existing portfolio a face-lift. Asset allocation is not a one-time event, it's a life-long process of progression and fine-tuning.
It is important to take a holistic approach in developing an asset allocation strategy. Here are two types of asset allocation strategies: 1. Strategic asset allocation: This strategy is a disciplined approach that involves assigning weights to different asset classes on the basis of an investor’s risk and return objectives and the capital market expectations. It is based on modern portfolio theory, which assumes that every investor is rational and shows risk aversion (i.e. desire for high returns with the lowest possible risk). Every financial planner would customize this strategy according to your needs and factor it in your financial plan. This is also called a “policy portfolio.” The financial planner would also assign a maximum permissible range for each asset class, e.g., if stocks have an allocation of 50% in your policy portfolio, the financial planner can assign a permissible range of 46% to 54% for your stock allocation. This means that any time the stock percentage ventures outside this range, your portfolio will have to be rebalanced. If it goes below 46%, then you will buy additional stocks and if it goes above 54%, you will have to sell stocks. 2. Tactical asset allocation: While strategic asset allocation is implemented over the long term, tactical asset allocation allows investors to make short-term deviations from asset weights assigned in strategic asset allocation strategy. These short-term deviations are achieved by implementing a moderately active strategy. The Bottom Line Asset allocation is the most important part of the portfolio construction process. It can be strictly passive in nature or can become a very active process. The asset mix decision heavily depends on an individual’s age, risk tolerance, goals, time horizon and capital market expectations. It is important to note that an asset mix for one person may be completely inappropriate for another. Investors looking to make an investment for a long period of time tend to focus their portfolios on stocks. One reason for this is that common stock tends to outperform most other financial instruments over a long enough time frame. Investors who are looking to maximize returns over a shorter period, on the other hand, often diversify their portfolios by including investments other than stocks. It is this principle that helped to guide the development of the concept of asset allocation. Asset allocation refers to an investment technique which aims to balance risk and create diversification within a portfolio by dividing assets across a number of major categories (stocks, bonds, real estate, cash, etc.). Because each asset class in the portfolio experiences different levels of risk and return, each tends to behave differently over a longer span of time. While one type of asset may be increasing in value, another may be decreasing. One central tenet of the concept of asset allocation is that older investors tend to look for lower levels of risk. After retiring, an investor may need to depend upon savings as the only source of income. Individuals at or nearing retirement age tend to invest more conservatively, as it’s crucial that they preserve their assets at this stage. How does one go about determining the correct mix of different types of assets in a portfolio? Like many of the other concepts covered in this tutorial, the answer is complicated and depends on who you ask. There are many different approaches to allocating assets. There are a number of general principles (but the most common approach is to shift emphasis toward lower-risk instruments (like bonds and treasuries) as one gets closer to retirement. Of course, a stock market crash or other significant disturbance can still cause problems for those who invest conservatively, as many investors saw in the bear markets of 2000 and 2001.
What Is Asset Allocation? Asset allocation is one of the most important steps in your portfolio management process. The initial step for the financial planner is to determine your required rate of return based on your financial goals, risk tolerance and time horizon. The second step is to ascertain capital market expectations, as well as the expected return and expected volatility of each asset classes. There are two categories of asset classes: 1. Traditional asset classes include stocks, bonds, and cash 2. Alternative asset classes include mutual funds, commodities, real estate, private equity, hedge funds The third step is asset allocation, in which the financial planner develops a strategy of how much money to invest in each asset class for you to achieve your return objective at a risk level that you are able and willing to accept. The premise of asset allocation is that each asset class has a different risk and return characteristic, thus providing the investor with risk diversification benefits. For instance, a 20% stock / 80% bond portfolio will provide lower risk and return and a more regular cash flow than an 80% stock/20% bond portfolio. It is also important to note that the latter is a riskier portfolio and is more suitable for young individuals in their twenties who have a longer time horizon and can tolerate stock market volatility. On the other hand, the first portfolio is more suitable for individuals who are nearing retirement and cannot withstand a drastic decline in their portfolio. Why Is Asset Allocation Important? As explained above, the most significant benefit of asset allocation is that it provides diversification and helps the investor manage the risk of his/her portfolio. While most people do understand this concept, they would still focus on which investment would outperform or whether equity markets would trend up or down. Although these are important considerations, many professional money managers believe that asset allocation is the most important decision for the investors What Are Different Asset Allocation Strategies? As previously mentioned, the most important factors in determining the asset mix are risk tolerance and time horizon. An individual with a longer time horizon and higher risk tolerance should automatically tilt his or her portfolio toward stocks. According to a traditional rule of thumb, the percentage of stock allocation should be equal to 100 minus your age. So, if your age is 25, then 75% of the portfolio should be allocated toward stocks. Over the years, many experts have expressed concern over using this rule as they believe it results in extremely conservative portfolios for retirees. Also, following the aforementioned rule deprives an individual of venturing into other asset classes other than stocks and bonds. For instance, during high inflation, stocks, bonds, as well as cash and cash equivalents tend to underperform. To combat inflation (in financial terms we can say to hedge inflation risks), individuals can invest their money in real estate and commodities to achieve low variability in their portfolio returns.