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Asset Allocation

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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.
 

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