One of the most important aspects of financial planning is an investor’s asset allocation. Asset allocation encompasses what type and how many securities to allocate for investment purposes, based on an investor’s risk tolerance level and goals.
Asset allocation involves both tactical decisions, such as deciding to invest in a specific sector or investment vehicle, and strategic decisions about how to divide assets between stocks (high risk), cash (low risk) and bonds (medium risk). Asset allocation has a significant effect on long-term returns. By way of example, two people could invest exactly the same amount of capital at the same time in two funds and end up with very different final values due to different asset allocations.
Asset allocation is a process to determine the mix of asset classes that would be used by an investor in order to achieve the investment objective. To achieve this, multiple considerations should be taken into account. This includes personal objectives, financial situation and risk tolerance, as well as the ability of an individual or organization to get highly diversified asset classes from available investments.
Asset allocation in wealth management
Asset allocation is part of wealth management, a broader concept which encompasses long-term investment strategies and planning for retirement as well as other financial goals such as funding college education or starting a business. Every investor has an idea of where they want to go with their money but they don’t have enough information with which to make good decisions.
Fintalent’s asset allocation consultants consider asset allocation to be the most important aspect of wealth management with many ways of approaching the subject. Strategic asset allocation, asset location and tactical asset allocation are three examples of different approaches to this subject. Strategic asset allocation is a long-term approach, while tactical asset allocation refers to a shorter-term approach. Using these models together allows an investor to create a portfolio that best suits their needs and expectations.
Generally speaking, Asset Allocation refers to two types: strategic and tactical.
Strategic asset allocation is a long-term approach to investing, whereas tactical asset allocation refers to a shorter-term approach. This can be compared to a longer term plan versus the smaller steps needed to achieve your goals.
Core principles of Asset Allocation
1) The benefit of diversification outweighs the added risk of one’s specific portfolio.
2) Diversification allows for risks and returns on investments to offset each other, therefore lowering volatility in your portfolio.
3) An investment portfolio should be rebalanced at least annually, or more often if necessary.
Who is Asset Allocation for?
Asset allocation is for those with the desire to invest wisely and achieve their financial goals, but do not want to spend the time to do research regarding various investment opportunities.
How does Asset Allocation work?
Asset allocation is a long-term investment strategy that divides and distributes an investor’s wealth into various types of assets.
There are three basic factors that determine the portfolio’s asset allocations:
1) The risk profile of an investor.
2) The investor’s financial goals.
3) The availability of risk-free assets.
In a nutshell, the best asset allocation is the one that suits the investor’s goals, features risk with sufficient diversification, and continues to grow or maintain at least some of the returns. A complete investment plan will include a security analysis along with an asset allocation strategy that takes into account one’s personal financial situation. An investor should not expect perfect forecasts from their assets because there are too many variables to consider as well as computational bottlenecks in financial services. The investment industry changes quickly and some significant advances are changing how asset allocations are being calculated and managed by financial institutions. The use of ETFs and mutual funds are making an impact on the asset allocation techniques used today.
Basic Asset Allocation Approaches
a) Diversified portfolio
b) Bond portfolio and
c) Equity-based portfolio.
A chosen approach is based on an investor’s appetite for risk and the amount of money being invested in various asset classes, including stocks and bonds. Any of the three types of portfolios can be combined according to the needs of investors for a balanced, diversified portfolio. The aim of all these portfolios is to match a given investment objective with a mix of assets which delivers returns, at least some risk management and investment opportunities with favorable tax consequences due to tax-exempt status.
Every investor has different goals, wants and needs; therefore the objective of wealth management is to help each individual investor reach those goals. In advising people on how to allocate their assets, financial advisors should consider risk tolerance, time horizon and life objective.
Asset allocation can also refer to the placement of the asset within a different tax regulated account. In other words, where you own your stock or funds is just as important as the number of stocks or quantity of shares you own. This aspect of asset allocation can have a large impact on the overall performance of your portfolio.
Asset allocation also implies that this balance will change over time in accordance with personal wealth, risk tolerance and age. The greater a person’s age and financial stability (i.e., good job history), the greater percentage allocated to equity investments like stock or stock mutual funds, while those who are younger may be advised to invest more in lower-risk vehicles such as bonds or bank certificates of deposit.
Investors typically divide the money between two broad categories: domestic investments such as stocks and bonds, which can be sold quickly when the need arises, and international investments such as stocks, bonds, commodities (such as gold), currencies (like the US dollar) and real estate abroad. Within each category, a number of subcategories are typically made, depending on the investor’s investment goals – for example, some investors want to invest in value investments (like bonds or real estate), but also want exposure to growth investments for extra income.
Asset allocation is used by investors as an investment strategy to generate better risk-adjusted returns or to reduce risk through diversification. A good asset allocation plan should be able to balance both growth and potential risk exposure, and it is typically considered best done over many years or even decades.
Before the emergence of modern portfolio theory (MPT), most financial advisers recommended that portfolios contain a sufficient amount of assets that can accommodate your age, expected retirement dates and desired living standard. However, the emergence of MPT shed new light on the asset allocation decision. The theory suggests that one can benefit more by diversifying their portfolio amongst different assets and rebalancing them along the way. Rebalancing involves buying and selling assets when they deviate from their target levels to maintain constant proportions of a portfolio. These strategies can imply higher turnover rates (buying and selling) than previously recommended, which at times may lead to transaction costs impact in reducing returns.
