Asset allocation is an important aspect of building a diversified portfolio. It is a strategy in which an investor divides capital among several asset classes, such as stocks, bonds, derivatives, and alternatives. While asset allocation does not guarantee a profit or protect against loss in a declining market, this strategy seeks to manage risk by diversifying exposure to asset classes at various locations on the risk spectrum.
What Makes It An Important Strategy
By achieving diversification, investors hedge against systemic risks across different asset classes. Just as investors may want to avoid a high concentration of exposure to a single stock, sector, or industry in the market, they should also consider diversifying their allocation across asset classes.
The way investors diversify their portfolios is a function of their investment objectives, which primarily are a gauge of an investor’s time horizon and appetite for risk. The prototypical asset allocation model differs for investors with varying investment objectives:
- Preservation of Capital: An investor aiming to preserve capital wants access to cash sooner than later, whether that be because he or she is nearing retirement or simply seeks refuge on the sidelines of the market during times of economic turmoil and volatility. This type of investor hopes to preserve their portfolio instead of deriving an income stream and invests heavily in cash and cash alternatives, including money market mutual funds, treasury bills, and commercial paper.
- Income: An investor building a portfolio that seeks to provide a steady and predictable stream of passive income will pursue exposure to assets that generate cash on a consistent basis. This investor profile will focus on allocating capital toward blue-chip stocks that pay regular dividends, bonds, real estate, and/or real estate investment trusts (REITs).
- Balanced: An investor that desires a balanced portfolio pursues long-term growth as well as income. This portfolio consists of a share of fixed income assets (such as municipal bonds and equity investments in stock markets) via a customized mix of U.S. equities or an ETF or mutual fund. Investors desiring balanced portfolios may have longer time horizons than those seeking to preserve capital, and may be saving for their children’s college or starting to think about retirement.
- Growth: An investor with an appetite for growth will be the most heavily concentrated in equity stocks because of the opportunity to build long-term wealth. Investors with this profile are less concerned with risk and more concerned with holding stocks and investments that should appreciate in value at a rate higher than the coupons offered on fixed-income investments. Because these investors are more concerned with long-term growth than the higher levels of risks associated with holding equities, these portfolios are hit hardest during recessionary periods of the economic cycle.
It is important to note that despite the differences in risk appetite across these different investment objectives, each type of investor will still seek diversification within the respective buckets of their portfolios. For example, growth investors hoping for above-average returns will still prioritize diversification with regard to their equity exposure by investing across multiple industries, such as airline stocks, tech stocks and real estate investment trusts (REITs). Investors aiming to preserve capital will perhaps allocate a third of their portfolio in treasury bills, another third in money market funds, and the remaining third in commercial paper investments.
Asset allocation strategies ultimately seek to manage risk and protect an investor’s portfolio from systemic risks in the market. Investors who allocate capital into equities, real estate, bonds, and other alternative investments are likely more protected from singular economic developments like a global recession or geopolitical event that may rattle the market. Investors can employ differing asset allocation strategies depending on their individualized investment objectives.
Deciding On Your Investments
Every investor faces a differing set of circumstances that determine their strategy when it comes to proper asset allocation. The primary determinant of asset allocation is the investor’s objectives and desired outcomes. An investor hoping to grow capital will generally aim for a higher exposure to equities, while an investor near retirement seeks to preserve capital by investing in treasury bills and other cash alternatives considered nearly risk-free.
An investor’s appetite for risk is another factor that determines how he or she allocates capital. The investor’s risk tolerance is a function of net worth, age, and previous investment experience. A high net worth individual will likely not have the same tolerance for risk that a young adult with access to significantly lower levels of capital seeking to build long-term wealth may have. Similarly, an individual working in finance may more actively cycle capital in and out of equities and bonds depending on developments in the economy than an individual with little knowledge of or regular exposure to the investment landscape in the U.S. or abroad.
A final factor deciding an investor’s investment decisions is his or her time horizon. A high net worth individual may have a lower appetite for risk than a younger investor because one individual aims reserve capital, while the other aims to grow it. These individuals’ differing time horizons also play a key role in investment decisions. The high net worth individual may want to retire within five years and does not need to take on additional risk. The younger investor, however, can afford to absorb losses associated with higher risk investments because he or she will have ample time to recover from these downturns.
An investor’s decisions are primarily a function of three factors: investment objectives, risk appetite, and time horizon. Understanding your goals in investing by defining each of these three factors will help you in determining where to allocate your capital.
The Bottom Line
Asset allocation is an important strategy in diversifying your portfolio and protecting yourself and your capital from system risks in different marketplaces. Investors who understand their objectives, tolerance for risk, and time horizon are well-equipped to build a portfolio that can withstand negative developments across asset classes. Whether you are seeking a stable stream of passive income, to preserve capital, to grow your children’s college education savings, or to aggressively grow long-term wealth, understanding the factors that determine the suitable investment strategy for your objectives is imperative.
Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor. Realized explicitly disclaims any responsibility for product suitability or suitability determinations related to individual investors.
Risk tolerance is an investor's general ability to withstand risk inherent in investing. There is no guarantee that an asset allocation model appropriately reflects your ability to withstand investment risk.