Asset Allocation

Asset allocation is a strategy that involves selecting a mix of investments calculated to achieve your financial objectives at a level of risk you can tolerate. Determining what percentage of your portfolio you allocate to each asset class, or investment category, can be one of the most important decisions you make with your investment adviser.

Some asset classes have the potential to increase the value of your portfolio, and others to provide regular income. Some categories, such as dividend-paying stocks, may do both. But no asset class produces strong returns all the time.

Asset allocation works because each asset class tends to perform somewhat differently at any given time. For example, when stocks are providing a strong return, bond returns often slump. And when investors are buying bonds, stock prices tend to slide. Investing in both stocks and bonds over time can help you avoid the amount of loss you could suffer in a stock downturn if you owned only stocks, or in a bond downturn if you owned only bonds.

MODEL PORTFOLIOS

Most asset allocation models, or plans, tend to focus on securities — stocks and bonds and the mutual funds or ETFs that invest in stocks and bonds — plus cash or its equivalents that can be easily liquidated, such as CDs and US Treasury bills.

The basic approach is to assign a percentage of your total investable assets to two or more of these asset classes, or investment categories. There are some standard models — such as 60% stock, 30% bond, 10% cash — that many pension funds use to produce the returns they need to meet their obligations to retired workers. Other models, which may emphasize other asset classes or include investment categories such as futures, options, or direct investments, are designed to help achieve certain goals or reflect different tolerances for risk. Generally, you’ll want to assign no more than 5% to 15% of your assets to these alternative investment categories.

Being invested in multiple asset classes means that the classes producing stronger returns at any given time can help balance the ones that are faltering. Adding alternative investments to your investment mix creates additional opportunities for achieving this balance.

JUST LIKE THE OTHERS — OR NOT?

The extent to which asset classes perform similarly to one another is called correlation. Positively correlated assets are affected in the same way by market-level, or systematic, risk, and their returns tend to move in the same direction. Negatively correlated assets are affected differently by market-level risk, and their returns tend to move in opposite directions. The extent to which assets perform similarly or differently indicates the level of their correlation, typically measured on a scale from 1 (most positive) to – 1 (most negative).

Many alternative investments tend to have low to negative correlations to traditional asset classes, as their values don’t tend to move in tandem with equity or bond markets. Though it may seem counterintuitive, adding higher-risk, negatively correlated assets to your portfolio can reduce the overall volatility and risk within your portfolio and increase your potential return.

MANAGING YOUR ALLOCATION

As the value of your investment portfolio increases or decreases, and as your financial goals and time frames change, you will probably want to modify your initial asset allocation. Your financial adviser may suggest you review and rebalance your portfolio once a year, or you may prefer to make a change when one traditional asset class is 15% more or less out of line with the allocation you’ve chosen.

The small percentage, 5% to 15%, that you allocate to alternative investments may remain the same, although the subclasses within this category may shift as your needs change.

In addition, brokerage firms and other financial advisers regularly revise and refine the allocation models they suggest to their clients to take current economic conditions into account.

ALLOCATION ISSUES

No single asset allocation is right for every investor. Your age, financial goals, time frame, risk tolerance, current financial wealth, and human capital all play a role in determining the right asset allocation for you. Financial wealth is what you currently own, including savings and investment accounts, your home, and other hard assets. Human capital is the present value of your future wages. Generally, as you age, your current financial wealth rises, and your human capital declines.

APPROACHES TO ALLOCATION

Depending on your situation, you may want to take a more or less aggressive approach to allocation.

Aggressive investors are willing to accept more volatility in the short term, require less current income, and have a long-term time frame in which to achieve their goals. A sample aggressive allocation model might be 60% stocks, 20% bonds, 10% cash, and 10% direct investments.

Moderate investors aim to buffer volatility, need to balance short-term and long-term goals, and often have less than ten years until retirement. A sample moderate allocation model might be 55% stocks, 30% bonds, 10% cash, and 5% direct investments.

Conservative investors want income-producing investments and are concerned about the risks in seeking long-term growth. They may have major short-term financial responsibilities or have large amounts invested in their own businesses. A sample conservative allocation model might be 30% stocks, 50% bonds, 15% cash, and 5% direct investments.


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