Asset allocation refers to an investment strategy in which individuals divide their investment portfolios between different diverse asset classes to minimize investment risks. The asset classes fall into three broad categories: equities, fixed-income, and cash and equivalents. Anything outside these three categories (e.g., real estate, commodities, art) is often referred to as alternative assets.
Strategies for Asset Allocation
In asset allocation, there is no fixed rule on how an investor may invest and each financial advisor follows a different approach. The following are the top two strategies used to influence investment decisions.
Dynamic Asset Allocation
The dynamic asset allocation is the most popular type of investment strategy. It enables investors to adjust their investment proportion based on the highs and lows of the market and the gains and losses in the economy.
Age-based Asset Allocation
In age-based asset allocation, the investment decision is based on the age of the investors. Therefore, most financial advisors advise investors to make the stock investment decision based on a deduction of their age from a base value of a 100. The figure depends on the life expectancy of the investor. The higher the life expectancy, the higher the portion of investments committed to riskier arenas, such as the stock market.
Insured Asset Allocation
For investors averse to risk, the insured asset allocation is the ideal strategy to adopt. It involves setting a base asset value from which the portfolio should not drop. If it drops, the investor takes the necessary action to avert the risk. Otherwise, as far as they can get a value slightly higher than the base asset value, they can comfortably buy, hold, or even sell.
Tactical Asset Allocation
The tactical asset allocation strategy addresses the challenges that result from strategic asset allocation relating to the long-run investment policies. Therefore, tactical asset allocation aims at maximizing short-term investment strategies. As a result, it adds more flexibility in coping with the market dynamics so that the investors invest in higher returning assets.
Factors Affecting Asset Allocation Decision
When making investment decisions, an investors’ portfolio distribution is influenced by factors such as personal goals, level of risk tolerance, and investment horizon.
Risk tolerance refers to how much an individual is willing and able to lose a given amount of their original investment in anticipation of getting a higher return in the future. For example, risk-averse investors withhold their portfolio in favor of more secure assets. In contrast, more aggressive investors risk most of their investments in anticipation of higher returns. Learn more about risk and return.
Goal factors are individual aspirations to achieve a given level of return or saving for a particular reason or desire. Therefore, different goals affect how a person invests and risks.
The time horizon factor depends on the duration an investor is going to invest. Most of the time, it depends on the goal of the investment. Similarly, different time horizons entail different risk tolerance.
If you as an investor have high liabilities, then even though you may be willing to take high amount of risk, your financial condition would make you a risk-averse investor. Irrespective of age, willingness to invest, nearness to his goals, risk tolerance or any other factor, you will be forced to only make safe investments as you cannot afford to let your investments suffer any setbacks due to market swings. Also, you must avoid taking loans or increasing liabilities to generate funds to invest in risk assets such as equities as any losses endured here might worsen your financials.
Your willingness to take risk which is a function of your age, income, expenses, nearness to goal, will be an important determinant while framing your financial plan. So, if your willingness to take risk is high (aggressive), you can skew your portfolio more towards the equity asset class. Similarly, if your willingness to take risk is relatively low (conservative), your portfolio can be skewed towards fixed income instruments, and if you are a moderate risk taker you can take a mix of equity and debt respectively.