What is Asset Allocation?
Asset Allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. Asset allocation is the process of developing a customized, diversified investment portfolio by strategically mixing different asset classes in varying proportions.
Asset allocation is based on the principle of diversification, but takes the process one step further. Diversification spreads money across different investments. Asset allocation, by strategically diversifying a portfolio among different asset classes, potentially offers investors a double advantage:
· To benefit from changing market cycles
· To reduce overall portfolio risk by offering a higher degree of diversification
Asset allocation therefore aims to reduce the “ups and downs” associated with investing and makes it easier to stick with investors’ long term investment objectives and avoid market timing.
Ultimately, the objective of a good asset allocation plan is to develop an investment portfolio that will help you reach your financial objectives with the degree of risk you find comfortable. A well-diversified plan will not outperform the top asset class in any given year, but over time it may be one of the most effective ways to realize your long-term goals.
For example: Have you ever noticed that street vendors often sell seemingly unrelated products - such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never - and that's the point. Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items- in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.
What are the different Asset Classes?
An asset class is a group of economic resources sharing similar characteristics, such as riskiness and return. There are many types of assets that may or may not be included in an asset allocation strategy.
Traditional Assets - The "traditional" asset classes are:
- Stocks: Stocks have historically had the greatest risk and highest returns among the three major asset categories
- Bonds: Bonds are generally less volatile than stocks but offer more modest returns. As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds
- Cash and cash equivalents (e.g., savings account) - The chances of losing money on an investment in this asset category are generally extremely low. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.
The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time. Allocation among these three provides a starting point. Usually included are hybrid instruments such as convertible bonds and preferred stocks, counting as a mixture of bonds and stocks.
Alternative Assets
Other alternative assets that may be considered include:
- Commodities: precious metals, nonferrous metals, agriculture, energy, others.
- Commercial or residential real estate (also REITs)
- Collectibles such as art, coins, or stamps
- Insurance products (annuity, life settlements, catastrophe bonds, personal life insurance products, etc.)
- Derivatives such as long-short or market neutral strategies, options, collateralized debt, and futures
- Foreign currency
- Venture capital
- Private equity
We will discuss Why Asset Allocation is important in the next article.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.