Asset Allocation 101

If you’re an avid reader of my blogs, you may have realized that I always advocate for proper asset allocation.

When you build an investment portfolio through optimal asset allocation, you’re more likely to achieve your financial goals.

In this article, I explain in detail what asset allocation is and cite the benefits it offers you as an investor.

What’s Asset Allocation?

As the name implies, asset allocation involves distributing your investible surplus across different asset classes.

Every time you see a pie chart on your account statements, you’re looking at your investment portfolio’s asset allocation. Asset allocation splits your investment portfolio by percentage across different asset classes (and within each asset class).

Asset allocation models typically range from conservative to very aggressive. A conservative asset allocation comprises safer investments like bonds and cash. In contrast, a very aggressive asset allocation is almost entirely composed of stocks and targets strong growth over the long term.

There’s no perfect one-size-fits-all asset allocation formula. How you decide to invest your money and the assets you hold is a highly personal decision.

Your age, time horizon, risk tolerance (can you sleep at night?), and financial goals all play a major role in finding the best combination of assets for your portfolio.

What Are Some of The Main Asset Classes?

There are several asset classes, but the main ones include:

Equities (Stocks) – Stocks represent partial ownership of publicly held companies. This asset class has historically offered the highest risk and returns. However, not all stocks are the same. Small-cap stocks are riskier and large-cap stocks have less risk. If you’re willing to put up with the volatility of stocks, you’re likely to realize the best positive returns over time.

Fixed Income (Bonds) – This asset class has historically shown less volatility compared to stocks, but the trade-off is that they offer lower returns. However, some types of bonds, such as junk and high-yield bonds, are riskier. Just as with stocks, you can pick bonds from different geographies, sectors, and capitalizations.

Cash and Cash Equivalents – This is the least risky asset class because there’s minimal risk of losing capital, but also the one that offers the lowest return of the 3 major asset categories. Besides cash, these investments might include savings accounts, money market accounts, Certificates of Deposit (CDs), or other cash-like securities.

Alternative asset classes include:

Property/Real Estate – Investing in real estate is viewed as a defensive exposure since it can hedge against inflation. Real estate can be in the form of rental or investment property, your primary residence, or even in shares of publicly-traded REITs – Real Estate Investment Trusts.

Gold – Gold is a traditional asset used as a real store of wealth. It acts as a hedge against inflation, weakness in the USD, and elevated volatility. Exposure to gold can be in many forms, including direct bullion, gold stocks, and ETFs. 

Commodities – Commodities refer to the raw materials that get made into other things. Commodities include crude oil, metals, livestock, and grains.

In this article, I highlighted that regardless of the type of account you open, and with or without an employer’s help, you have access to the same investment products.

Why Is Asset Allocation Important?

Asset allocation is an essential part of investing and retirement planning.

By allocating assets strategically, you’re basically adopting an investment strategy that can balance your portfolio’s risk and reward.

If you’re not taking on enough risk, you might not generate high enough returns to reach your goals. On the other hand, if you’re taking on excessive risk, you may not have enough money when you need to access it.

Some of the benefits of proper asset allocation include:

1.       Minimizes Investment Risk

While each asset class has its fair share of risks and rewards, returns of stocks, bonds, cash, etc., tend to move in different directions at the same time.

Market conditions that cause one asset class to outperform during a specified timeframe might cause another to underperform.

Diversifying your investment portfolio across different assets minimizes the risk of loss from putting your money in any one single asset class.

The 1991-92 recession, the late 2000 technology bubble pop, the unforgiving Global Financial Crisis of 2008), and the recent COVID 19-induced global recession are some clear reasons why you need a diversified portfolio.

2.       Optimizes Returns

Without proper asset allocation, many investors end up investing in an ad-hoc manner. This makes it hard for them to evaluate whether the ROI is sufficient to attain their short- and long-term financial goals.

Proper asset allocation will help you evaluate how much return you can expect on your investments based on the risks you’re taking.

3.       Helps Your Investments to Align with Your Time Horizon

Time horizon is a key factor in deciding asset allocation.

Depending on your investment time horizon, you can allocate a significant portion of your investible surplus in a certain asset class to realize your financial goals.

Proper asset allocation will help you balance the correct mix of debt, equity, real estate, gold, and cash based on your time horizon to hit your financial goals.

4.       Protects Against Inflation

Inflation, exacerbated by the surge in commodity and energy prices following Russia’s invasion of Ukraine, is one of the biggest risks investors face in 2022.

Inflation affects everyone, but you’ll be more affected if you have a longer investment horizon. The reason for this is that inflation reduces your purchasing power, and over extended periods, it can potentially erode your net worth in real terms.

If you’re a long-term investor seeking real growth or worried about inflation risk, strategic allocation comprising a combination of growth-oriented and inflation-sensitive assets will effectively help hedge against unexpected or rising inflation.

Market segments with higher growth potential include emerging markets equities and small-cap stocks, whereas inflation-sensitive assets include real asset equities and Treasury Inflation-Protected Securities (TIPS). Naturally, these allocation will increase risk and should be handled purposefully.

Best Practices for Asset Allocation

• Pick the right asset mix (the higher the risk, the higher the reward; the lower the risk, the lower the reward)

• Consider investing beyond bonds and stocks

• Consider investing in international companies

• Opt for both short- and long-term investments

• Take time to learn about the sectors before investing

• Be aware of cost

• Re-evaluate your asset allocation periodically (especially at major life milestone)

Conclusion

Building an investment portfolio through optimal asset allocation is vital if you endeavor to secure your financial future.

With a well-thought-out asset allocation in place, you can rest assured that you’ll efficiently earn nice returns base on appropriate risk exposure.

If you are uncertain about the optimal asset allocation for you, always seek help in obtaining the most efficient strategy that adapts to long-term trends in the market. This will help you accomplish your financial goals.