What is asset allocation and how does it affect your investment portfolio? This can be a long and complex question. In short, asset allocation, simply put, is an important part of your overall investment strategy. It involves selecting assets that complement your financial objectives, risk appetite, time frame, and investment style. Essentially your asset allocation plan is the combination of assets in your overall investment portfolio.
Usually, these assets are usually fixed income, equities, and liquid cash equivalents. These categories represent different risk thresholds; hence it is important for an investor to evaluate and choose which category would suit them best depending on their individual investing needs. For instance, if an investor is conservative and is looking to allocate only ten percent of their total investing capital to equities then they would most likely invest in stocks and bonds. If the same investor were to choose to add ten percent of their investing capital to stocks, then they would be in a strong defensive position, meaning that they would have enough defensive stocks to cushion their downside risk if the market fell drastically.
The asset allocation strategy is dependent on the investor’s risk appetite, time horizon, tolerance for risk, as well as their overall investment style. A key concept to remember when it comes to asset allocation strategies is that it is all about the three main asset classes. These three basic categories of assets are stocks, bonds, and mutual funds. Stocks represent the active manager’s actual investments; bonds are the liabilities of the company; and mutual funds are an investor’s stock in a fund that usually includes both stocks and bonds. Essentially when you break it down, asset allocation simply refers to the management strategy or investment philosophy of an investor.
So, what exactly is asset allocation? It is simply allocating your investing capital into the appropriate mix of assets. You will probably want to vary this a little bit, depending on your risk appetite, your personal preferences, and your overall investment goals. This is a broad overview of asset allocation, but hopefully it helps you get started.
Basically there are two ways to allocate your investing dollars: one way to earn dividends and another way to hold your investment until it matures. Dividends are a return you receive from your investing. Holders of mutual funds don’t receive any type of dividend. It is important to remember, though, that even if you do not reinvest dividends will be received by you and they will be taxable. Just be sure to take note of what you are paying yourself, as well, especially if you are holding more than one asset.
Another way to do your asset allocation involves the method of spreading your risk between a number of investment alternatives. For example, you could invest in fixed term CDs or savings accounts, commercial real estate, stocks, and bonds. There are advantages and disadvantages to each of these asset classes, and you may want to study each one before making a final decision. In general, stocks have the greatest volatility and are your best bet for short term profit growth. However, you should be aware that they also carry the greatest risk.
Fixed income securities are a great way to diversify and are generally offered in both interest-bearing and negative amortization forms. These types of investments come at a lower cost than stocks, which is why they are often included in all asset allocation programs. Because of their higher risk, they are also considered lower risk options for some people. On the other hand, fixed income securities have the potential for tremendous growth.
Finally, another way to incorporate an asset allocation strategy into your overall portfolio is with a more aggressive and faster time frame approach. This type of approach takes advantage of the fact that some investments gain volatility over time and will quickly increase in price. Therefore, a greater amount of your allocation funds will be invested in these investments and you will receive a larger percentage of your return in the form of higher volatility. To some, this represents a greater risk, but to those who are willing to take on a bit more risk in order to receive a higher return, this time frame asset allocation strategy may represent a valuable part of their overall portfolio.
