What is Asset allocation?
Asset allocation is a strategy for accumulating wealth that investors require to meet their needs and aspirations. It seeks to manage risk through diversification, and its effectiveness is determined primarily by your time horizons and risk tolerance.
In contrast to strategies that focus on the performance of individual assets, asset allocation entails carefully calibrating the ratios that different asset categories take in your portfolio while taking into account the overall portfolio’s specific characteristics and your personal investor profile.
Importance of Asset Allocation
An investor can protect against significant losses by including asset categories with investment returns that fluctuate in response to changing market conditions in a portfolio. Historically, the returns on the three major asset classes have not fluctuated at the same rate. Market conditions that cause one asset category to perform well frequently cause another asset category to perform averagely or poorly. By investing in more than one asset class, you reduce the risk of losing money and smooth out your portfolio’s overall investment returns. If the investment return on one asset category falls, you’ll be able to offset your losses in that asset category with higher investment returns in another asset category.
You identify the asset classes that are appropriate for you and decide how much of your investment dollars should be allocated to each class using asset allocation.
Here’s a look at the three major asset classes you’ll be looking at when using asset allocation:
Historically, stocks have had the highest risk and highest returns of the three major asset classes. Stocks are the “heavy hitter” in a portfolio, with the greatest potential for growth. The stock market hits home runs but also strikes out. Stocks are a high-risk investment in the short term due to their volatility. Large company stocks, for example, have lost money roughly one out of every three years on average. And the losses have been quite dramatic at times. However, investors who were willing to ride out the volatile returns of stocks over long periods of time were generally rewarded with strong positive returns.
Bonds are less volatile than stocks but provide lower returns. As a result, an investor approaching a financial goal may increase his or her bond holdings relative to stock holdings because the lower risk of holding more bonds is appealing to the investor despite their lower potential for growth. You should keep in mind that certain types of bonds, like stocks, offer high returns. These bonds, known as high-yield or junk bonds, are, however, riskier.
Cash and cash equivalents, such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds, are the safest investments but provide the lowest return of the three major asset classes. In general, the chances of losing money on an investment in this asset category are extremely low. Many cash equivalent investments are guaranteed by the federal government. Investment losses in non-guaranteed cash equivalents occur on a rare basis. Inflation risk is the primary concern for investors who invest in cash equivalents. This is the danger of inflation outpacing and eroding investment returns over time.
The most common asset classes are stocks, bonds, and cash. When investing in a retirement savings programme or a college savings plan, you will most likely choose from one of these asset categories. However, other asset classes exist, such as real estate, precious metals and other commodities, and private equity, and some investors may include these asset classes in their portfolios. Investing in these asset classes typically entails category-specific risks. Before making any investment, you should understand the risks involved and ensure that the risks are appropriate for you.