Asset Allocation

Introduction

In this post, we'll explore the most important aspects of asset allocation you need to know, explain how to calculate and interpret asset allocation, and discuss how implementing a thoughtful asset allocation strategy can help you (and your portfolio!) stay balanced and grow over time.

This article covers the definition of Asset Allocation and a general explanation of how asset allocation could affect your overall investment strategy.
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What is Asset Allocation?

Definition of Asset Allocation

Asset allocation is the strategic distribution of an investment portfolio across different asset classes to balance risk and reward according to an individual's goals, risk tolerance, and investment horizon. It typically involves dividing investments among stocks, bonds, cash, real estate, and other assets to create a diversified portfolio that can weather various market conditions.

While there are many factors to consider in asset allocation, these are the ones that best predict how your portfolio will perform over time.

1. Risk tolerance

Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. It's a crucial factor for determining the right mix of assets in your portfolio.

To assess your risk tolerance, consider factors like:

• Your financial goals
• Your investment time horizon
• Your emotional response to market fluctuations

For example, if you're comfortable with high volatility and have a long time horizon, you might have a high risk tolerance. On the other hand, if you prefer stability and have a shorter time horizon, your risk tolerance would be lower.

Understanding your risk tolerance is essential for creating an asset allocation that aligns with your comfort level and financial objectives.

👉 read our detailed post about risk tolerance & risk appetite here
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2. Time horizon

Time horizon refers to the expected period an investor will hold their investments before needing to access their capital. It's a critical factor in determining the appropriate asset allocation.

To calculate your time horizon, consider:

• When you'll need to start withdrawing from your investments
• The duration of your financial goals (e.g., retirement, buying a house)

For instance, if you're 30 years old and investing for retirement at 65, your time horizon would be 35 years.

A longer time horizon generally allows for a more aggressive asset allocation, as there's more time to recover from market downturns. Conversely, a shorter time horizon often calls for a more conservative approach.

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3. Asset class distribution

Asset class distribution is the percentage of your portfolio allocated to different types of investments, such as stocks, bonds, and cash equivalents.

To calculate your asset class distribution:

1. List all your investments
2. Categorize them by asset class
3. Calculate the total value of each asset class
4. Divide each asset class value by your total portfolio value

For example, if you have a $100,000 portfolio with $60,000 in stocks, $30,000 in bonds, and $10,000 in cash, your asset class distribution would be:

• Stocks: 60%
• Bonds: 30%
• Cash: 10%

Your ideal asset class distribution will depend on your risk tolerance, time horizon, and financial goals. Keep in mind, a financial advisor can help you navigate the dynamic challenges of this.

4. Rebalancing frequency

Rebalancing frequency is how often you adjust your portfolio to maintain your target asset allocation. It's an important aspect of managing your investments over time.

To determine your rebalancing frequency:

1. Decide on a regular schedule (e.g., quarterly, annually)
2. Set thresholds for when to rebalance (e.g., when an asset class deviates by 5% from its target)

For instance, you might choose to review your portfolio quarterly and rebalance when any asset class is off by more than 5% from its target allocation.

Regular rebalancing helps maintain your desired risk level and can potentially improve returns by systematically buying low and selling high.
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5. Diversification within asset classes

Diversification within asset classes refers to spreading your investments across different sectors, industries, or geographic regions within each asset class.

To assess your diversification:

1. List your holdings within each asset class
2. Categorize them by sector, industry, or region
3. Calculate the percentage each category represents within the asset class

For example, within your stock allocation, you might aim for:

• 30% technology
• 20% healthcare
• 15% financials
• 15% consumer goods
• 20% other sectors

Keep in mind this is just an example. Proper diversification can help reduce risk by ensuring that your portfolio isn't overly concentrated in any single area; this is essentially the core purpose of asset allocation.

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How does implementing asset allocation improve your investment strategy?

Understanding and implementing asset allocation isn't just about creating a balanced portfolio – it's about using this knowledge to make better investment decisions, adapt to changing market conditions, and improve your long-term financial outcomes.

Here are some of the tangible improvements you'll notice as you focus on asset allocation:

1. Managing risk more effectively

By carefully allocating your assets based on your risk tolerance and time horizon, you can create a portfolio that aligns with your comfort level while still pursuing your financial goals.

You won't be taking on unnecessary risk. If your asset allocation is too aggressive for your risk tolerance, you'll know to adjust it before market volatility causes undue stress or panic selling.
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2. Setting realistic expectations

Having a clear understanding of your asset allocation makes it much easier to set realistic expectations for your portfolio's performance.

Rather than chasing unrealistic returns or panicking during market downturns, you can use your asset allocation to gauge whether your portfolio is performing as expected given current market conditions.
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3. Adapting to life changes

One of the lasting benefits of focusing on asset allocation is that you'll be able to adjust your investment strategy as your life circumstances change.

As things evolve – like getting married, having children, or approaching retirement – you'll have a framework for updating your portfolio to reflect your new goals and risk tolerance.
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4. Potentially improving returns

The ultimate goal, of course, is to grow your wealth over time.

When you implement a thoughtful asset allocation strategy, you'll be doing a lot less guessing and hoping for market miracles. Instead, you'll have an investment approach that you can refine and optimize over time.

You'll be able to take advantage of market opportunities while managing downside risk, which means more of your investment decisions will be strategic rather than reactive.

Asset Allocation by Age

Adapting Your Strategy Over Time

As you progress through different stages of life, your financial goals, risk tolerance, and time horizon naturally evolve. This means your asset allocation strategy should change as well. Here's a general guide to how your asset allocation might shift as you age:

20s and 30s: Aggressive Growth

• 80-90% stocks
• 10-20% bonds
• 0-5% cash

In your younger years, you have time on your side. With a long investment horizon, you can afford to take on more risk for potentially higher returns. Focus on building a diversified portfolio of stocks, including growth stocks and international equities.
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40s and Early 50s: Balanced Growth

• 70-80% stocks
• 20-25% bonds
• 5-10% cash

As you enter your peak earning years, start to gradually reduce risk. Increase your allocation to bonds while maintaining a significant portion in stocks for continued growth.
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Late 50s and Early 60s: Conservative Growth

• 50-60% stocks
• 30-40% bonds
• 10-20% cash

With retirement on the horizon, shift towards a more conservative allocation. Increase your bond holdings to protect against market volatility, but maintain some stock exposure for growth.
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65 and Beyond: Income and Capital Preservation

• 30-50% stocks
• 40-60% bonds
• 10-20% cash

In retirement, focus on preserving capital and generating income. Increase your allocation to bonds and cash, while keeping some stocks to help your portfolio keep pace with inflation.

Remember, these are general guidelines and should be viewed as an example. Your specific allocation should be tailored to your individual circumstances and goals.

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Importance of Working with a Financial Advisor

While understanding asset allocation is crucial, working with a financial advisor can provide invaluable benefits:

Guidance and Objectivity

A financial advisor can:

• Offer an objective perspective on your financial situation
• Help you avoid emotional decision-making during market volatility
• Provide expertise on complex financial matters
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Accountability and Goal-Setting

Your advisor can:

• Help you set realistic, achievable financial goals
• Create a structured plan to reach those goals
• Hold you accountable for following through on your financial commitments

👉 read our guide on the full list of services provided by financial advisors

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Comprehensive Financial Planning

Beyond asset allocation, an advisor can assist with:

• Tax planning strategies
• Estate planning
• Insurance needs
• Retirement planning
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Portfolio Reviews

An advisor will:

• Conduct periodic reviews of your portfolio
• Suggest rebalancing when necessary
• Adjust your strategy as your life circumstances change
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Behavioral Coaching

Perhaps one of the most valuable roles an advisor plays is that of a behavioral coach. They can:

• Help you stick to your long-term plan during market downturns
• Prevent you from making impulsive decisions based on market news or emotions
• Encourage good financial habits and discourage detrimental ones
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While it's possible to manage your own investments, a good financial advisor can be a powerful ally in your journey to financial success. They can provide the expertise, objectivity, and accountability needed to optimize your asset allocation strategy and help you achieve your long-term financial goals.

Frequently Asked Questions about Asset Allocation

Understanding and implementing asset allocation isn't just about creating a balanced portfolio – it's about using this knowledge to make better investment decisions, adapt to changing market conditions, and improve your long-term financial outcomes.

Here are some of the tangible improvements you'll notice as you focus on asset allocation:

What is asset allocation?

• Asset allocation is the process of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The goal is to balance risk and reward by apportioning assets according to an individual's goals, risk tolerance, and investment horizon.

Why is asset allocation important?

• Asset allocation is crucial because it determines the overall risk and return profile of your investment portfolio. By diversifying across different asset classes, you can reduce the impact of poor performance in any single asset class, helping to manage risk and improve the potential for long-term returns.

How do I determine the right asset allocation for me?

• The 'right' asset allocation depends on factors like your financial goals, time horizon, risk tolerance, and investment experience. Generally, younger investors with a longer time horizon may choose a more aggressive allocation (more stocks), while those nearing retirement may opt for a more conservative allocation (more bonds and cash). Working with a financial professional, such as an investment advisor or financial planner, could help in determining the 'right' allocation of your assets. Click here to find a financial advisor on AdvisorFinder.

What are the main asset classes?

• The main asset classes are:
  • Stocks (Equities): Represent ownership in companies and offer potential for high returns but come with higher risk.
  • Bonds (Fixed Income): Loans to corporations or governments that pay regular interest and are generally less risky than stocks.
  • Cash and Cash Equivalents: Highly liquid, low-risk investments like savings accounts or money market funds.
  • Real Estate: Property investments that can provide income and potential appreciation.
  • Commodities: Physical goods like gold, oil, or agricultural products, often used as a hedge against inflation.

How often should I rebalance my portfolio?

• Rebalancing involves adjusting your portfolio back to your target asset allocation. It's typically done on a regular basis, such as annually or quarterly, or when an asset class deviates by a certain percentage from its target allocation. Rebalancing helps maintain your desired risk level and can improve returns.

Can I change my asset allocation over time?

• Yes, your asset allocation should evolve as your life circumstances, financial goals, and risk tolerance change. For example, as you get closer to retirement, you might shift from a more aggressive allocation to a more conservative one to preserve capital and reduce risk.

What is the difference between strategic and tactical asset allocation?

• Strategic Asset Allocation is a long-term approach that sets a target mix of assets based on your goals, risk tolerance, and time horizon. It involves periodically rebalancing to maintain this allocation.
• Tactical Asset Allocation involves making short-term adjustments to your asset mix in response to market conditions or economic trends, with the goal of taking advantage of perceived opportunities.

What role does diversification play in asset allocation?

• Diversification is a key principle of asset allocation. By spreading investments across different asset classes and within those classes, you reduce the risk that poor performance in one investment will significantly impact your overall portfolio. Diversification can enhance returns while reducing volatility.

Is it possible to have too much diversification?

• While diversification is important, over-diversification can lead to diminished returns and excessive complexity. If you spread your investments too thinly across too many assets, the impact of strong-performing investments may be diluted, and managing the portfolio may become cumbersome.

What is the 60/40 portfolio, and is it still relevant?

• The 60/40 portfolio is a traditional asset allocation model that consists of 60% stocks and 40% bonds. It has been a standard for balanced portfolios, providing growth potential through stocks and stability through bonds. However, its relevance depends on market conditions and individual circumstances, and some investors may prefer more customized allocations.
• Read this post from Investopedia about "Why a 60/40 Portfolio Is No Longer Good Enough"

How does my time horizon affect my asset allocation?

• Your time horizon—the length of time before you need to access your invested funds—significantly influences your asset allocation. A longer time horizon allows for more aggressive investments like stocks, as there's more time to recover from market downturns. A shorter time horizon may require a more conservative approach to protect your capital.

What is risk tolerance, and how does it impact asset allocation?

• Risk tolerance is your ability and willingness to endure fluctuations in the value of your investments. It affects your asset allocation by determining how much of your portfolio should be in higher-risk, higher-reward assets like stocks versus lower-risk, lower-reward assets like bonds and cash.

How does inflation impact asset allocation?

• Inflation reduces the purchasing power of your money over time, which can erode the real returns on your investments. Asset allocation strategies often include inflation-protective investments, such as stocks, real estate, or commodities, which have the potential to outpace inflation over time.

Should I include international investments in my asset allocation?

• Including international investments in your portfolio can provide additional diversification, as different markets and economies may perform differently at various times. However, it also introduces currency risk and geopolitical risk, which should be considered when determining the appropriate allocation.

How can I start implementing asset allocation in my portfolio?

• To start implementing asset allocation, assess your financial goals, risk tolerance, and time horizon. Based on this assessment, determine the right mix of assets for your portfolio. You can adjust your existing investments or start building a new portfolio with these considerations in mind. Consulting with a financial advisor can also help in creating a tailored asset allocation strategy. AdvisorFinder is the place where people find financial advisor - get started here!