LEVEL: BEGINNER
Asset allocation is the process of allocating capital to different types of investment instruments, as well as specific strategies that are used to generate robust returns. Investment managers use allocation as a way to design a portfolio that will meet their targeted expectations of return.
The process of asset allocation involves distributing capital to a portfolio targeting different asset categories, such as stocks, bonds, commodities, alternative investments and cash. The process creates a mix of assets that are invested based on an investor’s risk-reward profile. This article will discuss different allocation techniques and the importance of generating diversified portfolio returns.
What Determines Asset Allocations
Allocations are generally determined by an investor’s risk-reward profile and time horizon. The higher the risks associated with an asset, the higher the expected return. The goal is to create a basket of assets that are generally uncorrelated to each other in an effort to generate returns in all types of market environments.
For example, an investor that is above retirement age would likely have a lower tolerance to risk, and therefore might be more interested in income producing financial instruments compared to instruments that will produce capital gains.
Asset allocation is one of the main determinants in finding the appropriate mix of financial products that will perform to target assumptions over time. Allocating funds to very risky assets such as high beta stocks will generate a portfolio with high volatility and high expected returns. A portfolio that is all cash and cash equivalents will be very safe, but generate very low returns.
Allocation analysis allows investors to create a mix of financial assets that will perform to expectation over the course of time. Historically, major asset classes have been uncorrelated, which means their movements do not perform in tandem. Holding riskier assets such as common stocks and income producing assets like bonds should generate returns in all types of market environments. Bonds generally are less volatile than stocks and are usually purchased during economic weakness. Bonds can be purchased directly, or through bond funds like ETFs and CEFs.
Asset allocation is constructive because it can determine if an investor will meet his or her financial target. If a portfolio is conservative, the upside is limited. If an investor is looking for robust capital gains, he or she is likely to fall short of expectations. If a portfolio is very risky, an investor could lose a substantial portion of capital during an adverse market move.
Principles of Allocation
Applying asset allocation principles to an investment portfolio will not only decrease the effects of adverse market movements, but it will help an investor take advantage of the inherent opportunities hidden within the chaos.
For instance, during a market crash, if you applied asset allocation to your investments, you would have many of your investments in secure assets that would be untouched by the market crash. Therefore, when others are wiped out, and equity and property prices are at all time lows, you can use some of your secure investments to snap up these bargains, thus reaping substantial profits when the market later recovers.
Allocation is a form of risk management, which will not only assist in generating solid market gains, but will also mitigate market and credit risks. There are numerous types of processes that are used to allocate a portfolio. Allocation can range from a discretionary style in which an investor uses guidelines to allocation capital, to statistical analysis where investors use a covariance matrix to find the best historic portfolio.
Diversification
A diversified portfolio should be structured in a way to create a portfolio that is diversified in multiple ways. Not only does an investor want to spread risk into numerous categories such as stocks, bonds and cash equivalents, but also diversify risk within a specific category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.
Diversification within stock categories means that an investor will look for stocks that increase in value during growth periods, as well as stocks that outperform when equity markets are underperforming. An example of a defensive type of stock sector is consumer staples. These types of companies sell items that are needed regardless of market conditions. Consumer staple companies produce items such as soap, toothpaste, and toilet paper, which outperform during weak economic times, but underperform when market conditions are strong.
Investors need to diversify within all categories. For bond investors, creating a diversified portfolio within corporate, municipal and sovereign is critical for long-term success. Investors also need to structure their bond portfolios by tenor to benefit from higher long-term yields and the safety of short-term yields.
Changing Allocations
The most common reason for changing your asset allocation is an alteration of your time horizon. For example, if your investment goal was retirement in 20 years from a date 10 years ago, your time horizon has change from 20 years to 10 years.
Most investors typically do not change their asset allocation based on the relative performance of asset categories. Instead they rebalance, meaning they shift their capital to reflect better performing assets.
The concept of rebalancing is resetting your portfolio back to your original asset allocation mix. This is important because over time some of your investments can grow differently from your original investment goals. By rebalancing, you will insure that your portfolio will remain in line with your long term investment goals.
There are basically three different ways you can rebalance your portfolio:
- You can sell off funds in over-weighted investments.
- You can purchase new investments for underweighted asset categories, but this will increase your overall capital exposed to the markets.
- You can shift your contributions to reflect a new balance which will take effect over time.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger a tax event or additional transaction fees.
Asset allocation and diversification are the keys to generating wealth over a long period of time and investors should venture to understand the theories behind successful allocation in an effort to maximize gains and minimize risks.