Asset allocation is an investment strategy in which investors divide their investment portfolio among diverse asset classes to minimize risk and maximize returns. The asset classes fall mainly into three categories: cash and equivalents, fixed income, and equities. Real estate, art, and commodities do not belong to these categories, and are therefore referred to as alternative assets.
When creating a portfolio distribution, investors are influenced by personal goals, risk tolerance, and investment horizon. Goals refer to personal aspirations to obtain a level of return or savings for a specific reason. Some people invest to purchase a home, start a business, or change careers. Others invest to fund their retirement accounts and leave a significant inheritance to their children. Therefore, different goals affect an investor’s attitude towards investments and risk.
Risk tolerance determines an individual’s willingness to lose a portion of their original investment to get a potentially high return in the future. Investors who are risk-averse and focus on capital preservation prefer to take the least risk possible. As a result, they recognize and accept that the limited growth of minimal-risk instruments is balanced against the relative security they need to preserve the capital they already have.
Some investors want to achieve a balanced risk by investing in instruments with minimal to medium risk in exchange for some growth potential. They look for regular income from interest and dividend earnings and are willing to expose investments to a moderate level of risk of loss of capital. Meanwhile, investors with higher risk tolerance look for dynamic growth when investing. Often, they want to grow the value of their investments and accumulate wealth over time through price appreciation. They invest in instruments with very high risk but have greater potential for high returns.
Lastly, investors consider the time horizon depending on the duration when investing. For instance, investors with short-term goals may invest only in low-risk instruments to avoid losses. However, investors with a long-term investment strategy may have more leeway to invest in higher-risk or more volatile instruments, since the economy can change over time.
Financial advisors usually suggest that investors diversify their investment in various asset classes to reduce portfolio risk and overall volatility. For this reason identifying the right asset allocation strategy is important, since different asset classes will provide different returns.
Age-based asset allocation is one of the common strategies to distribute investments. With this approach, the investment decision depends on the age of the investor. Financial advisors suggest that investors invest in stocks by subtracting their age from a base value of 100. For example, if the investor is 30 years old, their portfolio will consist of 70 percent invested in stocks and the remaining 30 percent allocated among other assets. This allocation should be adjusted accordingly as they grow older.
A constant-weight asset allocation is a strategy based on the buy-and-hold approach. If a stock loses value, investors should buy more of it. Conversely, investors should sell a portion of the stock’s shares when the stock’s price increases substantially, as long as they keep 5 percent of the original mix. Investors who want to be actively involved use the dynamic asset allocation approach. They adjust their investment allocation based on the highs and lows of the markets and the gains and losses in the economy.
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