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December 12 2009| Filed Under Accounting, Bonds, Financial Theory, Investing
Basics, Personal Finance, Portfolio Management
Investing 101 - Click Here!
The important task of appropriately allocating your available investment funds
among different assets classes can seem daunting, with so many securities to
choose from. Here we will illustrate what asset allocation is, its importance
and how you can determine your appropriate asset mix and maintain it.
What is Asset Allocation?
Asset allocation refers to the strategy of dividing your total investment
portfolio among various asset classes, such as stocks, bonds and money market
securities. Essentially, asset allocation is an organized and effective method
of diversification.
To help determine which securities, asset classes and subclasses are optimal
for your portfolio, let's define some briefly:
Large-cap stock - These are shares issued by large companies with a market
capitalization generally greater than $10 billion.
Mid-cap stock - These are issued by mid-sized companies with a market cap
generally between $2 billion and $10 billion.
Small-cap stocks - These represent smaller-sized companies with a market cap of
less than $2 billion. These types of equities tend to have the highest risk due
to lower liquidity.
International securities - These types of assets are issued by foreign
companies and listed on a foreign exchange. International securities allow an
investor to diversify outside of his or her country, but they also have
exposure to country risk - the risk that a country will not be able to honor
its financial commitments.
Emerging markets - This category represents securities from the financial
markets of a developing country. Although investments in emerging markets offer
a higher potential return, there is also higher risk, often due to political
instability, country risk and lower liquidity. (For further reading, see What
Is An Emerging Market Economy?)
Fixed-income securities - The fixed-income asset class comprises debt
securities that pay the holder a set amount of interest, periodically or at
maturity, as well as the return of principal when the security matures. These
securities tend to have lower volatility than equities, and have lower risk
because of the steady income they provide. Note that though payment of income
is promised by the issuer, there is a risk of default. Fixed-income securities
include corporate and government bonds.
Money market - Money market securities are debt securities that are extremely
liquid investments with maturities of less than one year. Treasury bills
(T-bills) make up the majority of these types of securities.
Real-estate investment trusts (REITs) - Real estate investment trusts (REITs)
trade similarly to equities, except the underlying asset is a share of a pool
of mortgages or properties, rather than ownership of a company.
Maximizing Return While Minimizing Risk
The main goal of allocating your assets among various asset classes is to
maximize return for your chosen level of risk, or stated another way, to
minimize risk given a certain expected level of return. Of course to maximize
return and minimize risk, you need to know the risk-return characteristics of
the various asset classes. Figure 1 compares the risk and potential return of
some of the more popular ones:
Figure 1
Equities have the highest potential return, but also the highest risk. On the
other hand, Treasury bills have the lowest risk since they are backed by the
government, but they also provide the lowest potential return.
Figure 1 also demonstrates that when you choose investments with higher risk,
your expected returns also increase proportionately. But this is simply the
result of the risk-return tradeoff. They will often have high volatility and
are therefore suited for investors who have a high risk tolerance (can stomach
wide fluctuations in value), and who have a longer time horizon.
It's because of the risk-return tradeoff - which says you can seek high returns
only if you are willing to take losses - that diversification through asset
allocation is important. Since different assets have varying risks and
experience different market fluctuations, proper asset allocation insulates
your entire portfolio from the ups and downs of one single class of securities.
So, while part of your portfolio may contain more volatile securities - which
you've chosen for their potential of higher returns - the other part of your
portfolio devoted to other assets remains stable. Because of the protection it
offers, asset allocation is the key to maximizing returns while minimizing
risk.
Deciding What's Right for You
As each asset class has varying levels of return for a certain risk, your risk
tolerance, investment objectives, time horizon and available capital will
provide the basis for the asset composition of your portfolio.
To make the asset allocation process easier for clients, many investment
companies create a series of model portfolios, each comprising different
proportions of asset classes. These portfolios of different proportions satisfy
a particular level of investor risk tolerance. In general, these model
portfolios range from conservative to very aggressive:
Conservative model portfolios generally allocate a large percent of the total
portfolio to lower-risk securities such as fixed-income and money market
securities.
The main goal with a conservative portfolio is to protect the principal value
of your portfolio. As such, these models are often referred to as "capital
preservation portfolios".
Even if you are very conservative and prefer to avoid the stock market
entirely, some exposure can help offset inflation. You could invest the equity
portion in high-quality blue chip companies, or an index fund, since the goal
is not to beat the market. (For further reading, see the tutorial All about
Inflation.)
A moderately conservative portfolio is ideal for those who wish to preserve a
large portion of the portfolio s total value, but are willing to take on a
higher amount of risk to get some inflation protection.
A common strategy within this risk level is called "current income". With this
strategy, you chose securities that pay a high level of dividends or coupon
payments.
Moderately aggressive model portfolios are often referred to as "balanced
portfolios" since the asset composition is divided almost equally between
fixed-income securities and equities in order to provide a balance of growth
and income.
Since these moderately aggressive portfolios have a higher level of risk than
those conservative portfolios mentioned above, select this strategy only if you
have a longer time horizon (generally more than five years), and have a medium
level of risk tolerance.
Aggressive portfolios mainly consist of equities, so these portfolios' value
tends to fluctuate widely. If you have an aggressive portfolio, your main goal
is to obtain long-term growth of capital. As such the strategy of an aggressive
portfolio is often called a "capital growth" strategy.
To provide some diversification, investors with aggressive portfolios usually
add some fixed-income securities.
Very aggressive portfolios consist almost entirely of equities. As such, with a
very aggressive portfolio, your main goal is aggressive capital growth over a
long time horizon.
Since these portfolios carry a considerable amount of risk, the value of the
portfolio will vary widely in the short term.
Nothing is Set in Stone
Note that the above outline of model portfolios and the associated strategies
offer only a loose guideline - you can modify the proportions above to suit
your own individual investment needs. How you fine tune the models above can
depend on your future needs for capital and on what kind of an investor you
are. For instance, if you like to research your own companies and devote time
to stock picking, you will likely further divide your equities portion of your
portfolio among subclasses of stocks. By doing so, you can achieve a
specialized risk-return potential within one portion of your portfolio. (For
further reading, see the tutorial Guide to Stock-Picking Strategies.)
Also, the amount of cash and equivalents, or money market instruments you place
in your portfolio will depend on the amount of liquidity and safety you need.
If you need investments that can be liquidated quickly or you would like to
maintain the current value of your portfolio, you might want to put a larger
portion of your investment portfolio in money market or short-term fixed-income
securities. Those investors who do not have liquidity concerns and have a
higher risk tolerance will have a small portion of their portfolio within these
instruments.
Maintaining Your Portfolio
Once you have chosen your portfolio investment strategy, it is important to
conduct periodic portfolio reviews, as the value of the various assets within
your portfolio will change, affecting the weighting of each asset class. For
example, if you start with a moderately conservative portfolio, the value of
the equity portion may increase significantly during the year, making your
portfolio more like that of an investor practicing a balanced portfolio
strategy, which is higher risk!
In order to reset your portfolio back to its original state, you need to
rebalance your portfolio. Rebalancing is the process of selling portions of
your portfolio that have increased significantly, and using those funds to
purchase additional units of assets that have declined slightly or increased at
a lesser rate. This process is also important if your investment strategy or
tolerance for risk has changed.
Conclusion
Asset allocation is a fundamental investing principle, because it helps
investors maximize profits while minimizing risk. The different asset
allocation strategies described above can help any investor do this regardless
of their risk tolerance and investment goals. In turn, choosing an appropriate
asset allocation strategy and conducting periodic reviews will ensure you
maintain your long-term investment goals and reach your desired return at the
lowest amount of risk possible.
by Shauna Carther
Shauna Carther is the vice president of content at Investopedia.com. In 2007,
she appeared as a guest on Moneytrack, a Public Broadcasting Service program
devoted to helping consumers learn to invest and take control of their
finances.