TOPICS:

1. Asset Allocation

2. Three Basic Asset Classes

3. How Asset Allocation Works

4. What is diversification?

5. What is rebalancing?

6. Factors Affecting Asset Allocation Decision

7. Strategies for Asset Allocation

8. Examples of Other Strategies

9. Why Is Asset Allocation Important?

1. Asset Allocation

Asset allocation involves dividing your investments among different assets, such as stocks, bonds, and
cash. The asset allocation decision is a personal one. The allocation that works best for you changes at
different times in your life, depending on how long you have to invest and your ability to tolerate risk.

What is Asset Allocation?

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.

When people gamble on sports, they generally bet all their money on one team. If their team wins,
they reap the rewards. And if their team loses? They lose it all.

When you invest, you don’t have to bet it all on one team. Instead, the best policy is to divide your
money among different types of assets. This is what we call asset allocation—done right, it safeguards
your money and maximizes its growth potential, regardless of which team is winning in markets.

What Is Asset Allocation?

Asset allocation is the process of dividing the money in your investment portfolio among stocks, bonds
and cash. The goal is to align your asset allocation with your tolerance for risk and time horizon.
2. Three Basic Asset Classes:

STOCKS (EQUITIES)

BONDS (FIXED-INCOME SECURITIES)

CASH

Stocks. Historically stocks have offered the highest rates of return. Stocks are generally considered riskier
or aggressive assets.

Bonds. Fixed income has historically provided lower rates of return than stocks. Bonds are typically
considered safer or conservative assets.

Cash and cash-like assets. While you don’t typically think of cash as an investment, cash equivalents like
savings accounts, money market accounts, certificates of deposit, cash management accounts, treasury
bills, and money market mutual funds are all ways that investors can enjoy potential upside with very
low levels of risk.

You’re probably already familiar thinking about your investment portfolio in terms of stocks and bonds.
But cash and cash-like assets are also an important piece of the asset allocation puzzle. These highly
liquid assets offer the lowest rate of return of all asset classes, but they also offer very low risk, making
them the most conservative (and stable) investment asset.

You can buy individual stocks or bonds to get your desired asset allocation. But new investors should
stick to exchange-traded funds and index funds.

There are countless funds to choose from, each of which owns a very broad selection of stocks or bonds
based on a particular investing strategy, like matching the performance of the S&P 500, or asset type, like
short-term municipal bonds or long-term corporate bonds.

3. How Asset Allocation Works

How Asset Allocation Works

Financial advisors usually advise that to reduce the level of volatility of portfolios, investors must
diversify their investment into various asset classes. Such basic reasoning is what makes asset allocation
popular in portfolio management because different asset classes will always provide different returns.
Thus, investors will receive a shield to guard against the deterioration of their investments.

How Does Asset Allocation Work?

With asset allocation, you divide your investments among stocks, bonds and cash. The relative
proportion of each depends on your time horizon—how long before you need the money—and risk
tolerance—or how well you can tolerate the idea of losing money in the short term for the prospect of
greater gains over the long term.

Asset Allocation & Time Horizon

Time horizon is a fancy way of asking when you’ll need to spend the money in your investment portfolio.
If it’s January and you’re investing for a vacation in June, you have a short time horizon. If it’s 2020 and
you plan to retire in 2050, you have a long time horizon.

With short time horizons, a sudden market decline could put a serious dent in your investments and
prevent you from recouping losses. That’s why for a short time horizon, experts recommend your asset
allocation consist mostly of cash assets, like savings or money market accounts, CDs, or even certain
high-quality bonds. You don’t earn very much, but risks are very low, and you won’t lose the money you
need to go to Aruba.

With longer time horizons, you may have many years or decades before you need your money. This
affords you the opportunity to take on substantially more risk. You may opt for a higher allocation of
stocks or equity funds, which offer more potential for growth. If your initial investment grows
substantially, you’ll need less of your own money to reach your investment goals.

With aggressive, higher-risk allocations, your account value may fall more in the short term. But because
you have a far-off deadline, you can wait for the market to recover and grow, which historically it has
after every downturn, even if it hasn’t done so immediately.

After each recession since 1920, it has taken the stock market an average of 3.1 years to reach pre-
recession highs, accounting for inflation and dividends. Even taking into account bad years, the S&P 500
has seen average annual returns of about 10% over the last century. The trouble is you’re never sure
when a recession or dip is going to arrive. As your investing timeline shrinks, you probably want to make
your asset allocation more conservative (bonds or cash).

For goals that have less well-defined timelines or more flexibility—you might want to take a trip to
Australia at some point in the next five years but don’t have a set date in mind—you can take on more
risk if you’re willing to delay things until your money recovers or you’re okay with taking a loss.

Asset Allocation & Risk Tolerance

Risk tolerance is how much of your investment you’re willing to lose for the chance of achieving a greater
rate of return. How much risk you can handle is a deeply personal decision.

If you’re the type of investor who’s not comfortable with big market swings, even if you understand that
they’re a normal part of the financial cycle, you probably have lower risk tolerance. If you can take those
market swings in stride and know that you’re investing for the long term, your risk tolerance is probably
high.

Risk tolerance influences asset allocation by determining the proportion of aggressive and conservative
investments you have. On a very simple level, this means what percentage of stocks versus bonds and
cash you hold.

Both high and low risk tolerances will lose money at some point in the investment cycle—even if it’s only
to inflation—but how big those swings are will vary based on the risk of the asset allocation you choose.

Even if you’re comfortable with a lot of risk, your investing timeline may influence you to hold a more
conservative portfolio. If you’re only a few years from retirement, for example, you might switch to a
bond- and fixed-income-heavy portfolio to help retain the money you’ve built up over your lifetime.
4. What is Diversification?

The practice of spreading money among different investments to reduce risk is known as diversification.
Diversification is a strategy that can be neatly summed up as “Don’t put all your eggs in one basket.”

One way to diversify is to allocate your investments among different kinds of assets. Historically, stocks,
bonds, and cash have not moved up and down at the same time. Factors that may cause one asset class
to perform poorly may improve returns for another asset class. People invest in various asset classes in
the hope that if one is losing money, the others make up for those losses.

You’ll also be better diversified if you spread your investments within each asset class. That means
holding a number of different stocks or bonds, and investing in different industry sectors, such as
consumer goods, health care, and technology. That way, if one sector is doing poorly, you may offset it
with other holdings in sectors that are doing well.

Some investors find it easier to diversify by owning mutual funds. A mutual fund is a company that pools
money from many investors and invests the money in stocks, bonds, and other financial products.
Mutual funds make it easy for investors to own a small portion of many investments. A total stock
market index fund, for example, owns stock in thousands of companies, providing a lot of diversification
for one investment.

A mutual fund won’t necessarily provide diversification, especially if it focuses on only one industry
sector. If you invest in narrowly focused mutual funds, you may need to invest in several to be
diversified. As you add more investments to your portfolio, you’ll likely pay additional fees and expenses,
which will lower your investment returns. So you’ll need to consider these costs when deciding the best
way to diversify your portfolio.

5. What is rebalancing?

Rebalancing is what investors do to bring their portfolio back to its original asset allocation mix.
Rebalancing is needed because over time, some investments will grow faster than others. This may push
your holdings out of alignment with your investment goals. By rebalancing, you will ensure that your
portfolio does not overweight a particular asset category, and you’ll return your portfolio to a
comfortable level of risk.

For example, you might start with 60% of your portfolio invested in stocks, but see that rise to 80% due
to market gains. To reestablish your original asset allocation mix, you’ll either need to sell some of your
stocks or invest in other asset categories.

There are three ways you can rebalance your portfolio:

You can sell investments where your holdings are over weighted and use the proceeds to buy
investments for underweighted asset categories.

You can buy new investments for underweighted asset categories.

If you are continuing to add to your investments, you can alter your contributions so that more goes to
underweighted asset categories until your portfolio is back into balance.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide
to use would entail transaction fees or tax consequences. Your financial professional or tax adviser can
help you identify ways that you can minimize these potential costs.

Some financial experts advise rebalancing at regular intervals, such as every six or 12 months. Others
recommend rebalancing when your holdings of an asset class increase or decrease more than a certain
pre-set percentage. In either case, rebalancing tends to work best when done on a relatively infrequent
basis.

Shifting money away from an asset class when it is doing well in favor of an asset category that is doing
poorly may not be easy. But it can be a wise move. By cutting back on current “winners” and adding
more current “losers,” rebalancing forces you to buy low and sell high.

Portfolio Rebalancing and Asset Allocation

Asset allocation isn’t a one-time event. Your desired asset allocation changes over time as you get closer
to your goals. But even before then, you may notice portfolio drift, or the movement of your allocations
away from where you set them. This could happen if stock values rise suddenly or if bond interest rates
(and their associated prices) fall.

Most experts recommend you check in on your portfolio once or twice a year to see how it’s doing.
Depending on your holdings’ performances, you may need to rebalance, or sell some securities and buy
others to bring your asset allocation back into line

6. 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.

1. Goal factors

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.

2. Risk tolerance

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

3. Time horizon

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.

For example, a long-term investment strategy may prompt an investor to invest in a more volatile or
higher risk portfolio since the dynamics of the economy are uncertain and may change in favor of the
investor. However, investors with short-term goals may not invest in riskier portfolios.
Factors to consider include your:

Time Horizon. Your time horizon is the number of months, years, or decades you need to invest to
achieve your financial goal. Investors with a longer time horizon may feel comfortable taking on riskier or
more volatile investments. Those with a shorter time horizon may prefer to take on less risk.

Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange
for potentially greater returns.

7. 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.

1. 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.

2. Life-cycle funds Asset Allocation

In life-cycle funds allocation or targeted-date, investors maximize their return on investment (ROI) based
on factors such as their investment goals, their risk tolerance, and their age. This kind of portfolio
structure is complex due to standardization issues. In fact, every investor has unique differences across
the three factors.

8. Examples of Other Strategies

1. Constant-Weight Asset Allocation

The constant-weight asset allocation strategy is based on the buy-and-hold policy. That is, if a stock loses
value, investors buy more of it. However, if it increases in price, they sell a bigger proportion. The goal is
to ensure the proportions never deviate by more than 5% of the original mix.

2. 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

3. 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.
4. 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.

Example of Asset Allocation

Let’s say Joe is in the process of creating a financial plan for his retirement. Therefore, he wants to invest
his $10,000 saving for a time horizon of five years. So, his financial advisor may advise Joe to diversify his
portfolio across the three major categories at a mix of 50/40/10 among stocks, bonds, and cash. His
portfolio may look like below:

Stocks

Small-Cap Growth Stocks – 25%

Large-Cap Value Stocks – 15%

International stocks – 10%

Bonds

Government bonds – 15%

High yield bonds – 25%

Cash

Money market – 10%

The distribution of his investment across the three broad categories, therefore, may look like this:
$5,000/$4,000/$1,000.

9. Why is Asset Allocation Important?

Why Is Asset Allocation Important?

Choosing the right asset allocation maximizes your returns relative to your risk tolerance. This means it
helps you get the highest payoff you can for the amount of money you’re willing to risk in the market.

You accomplish this balance through the same kind of diversification mutual funds and ETFs provide—
except on a much broader level.

Buying a mutual fund or an ETF may provide exposure to hundreds if not thousands of stocks or bonds,
but they’re often the same type of asset. A stock ETF offers diversification in stocks but you’re still
undiversified in terms of asset allocation. If one of the companies in an ETF goes bankrupt, your money
is probably safe. But if the whole stock market crashes, so do your savings.

To diversify your asset allocation, split your money between a stock ETF and a bond ETF. This helps
protect your money because historically, stocks and bonds have an inverse relationship: When one is up,
the other is generally down. Striking a balance between the two can position your portfolio to retain
value and grow no matter what markets are doing.
Three Asset Allocation Scenarios

To see how asset allocation works in the real world, here are retirement scenarios for three different
investors.

Investor A: 22 years old, 40 years to retirement, high risk tolerance

This investor is interested in growing their retirement savings over the next 40 years. They know the
market will have ups and downs but are more interested in holding investments that will offer the
potential for a higher rate of return. They want a diversified portfolio that allows them maximum
exposure to the stock market and its historically high rates of return.

Their retirement investment portfolio might look like this:

80% stocks

40% large-cap stocks

30% mid-cap stocks

30% small-cap stocks

15% bonds

5% cash

Investor B: 40 years old, 15 years to retirement, moderate risk tolerance

This investor still has more than a decade to go until retirement but less time to recoup any major
market losses. They’re willing to take on some risk to keep their money growing but don’t have the
luxury of multiple decades to replace any money they might lose between now and retirement.

They want a diversified portfolio that will offer modest upside but still protect them from major market
downturns. Their retirement portfolio might include:

60% stocks

60% large-cap stocks

20% mid-cap stocks

20% small-cap stocks

30% bonds

10% cash

Investor C: 60 years old, beginning retirement now, low risk tolerance

This investor is celebrating the end of their working years and looking forward to using their retirement
savings to explore new horizons. Losing money really isn’t an option since the money they’ve already
saved needs to last for the next 20 or more years.
They want a diversified portfolio that helps preserve their capital while offering them selected
opportunities for upside—but without taking on a lot of risk. Their retirement portfolio might look like:

30% stocks

100% large-cap stocks

50% bonds

20% cash

As you can see, differing time horizons and appetite for risk dictate how these investors choose to
allocate the assets in their portfolios. While these profiles are only samples, they should give you an idea
of how asset allocations can change from one risk tolerance and time horizon to another.

Asset allocation is a fundamental investment decision that involves dividing an investment portfolio
among different asset classes, such as stocks, bonds, and cash equivalents. The objective of asset
allocation is to balance risk and return by diversifying investments across different asset classes that
have varying levels of risk and return potential.

Asset allocation decision is a critical decision for investors as it has a significant impact on the
performance and risk of a portfolio. Asset allocation is influenced by several factors, including an
investor's risk tolerance, investment goals, time horizon, and market conditions.

Asset allocation can be divided into two main approaches: strategic and tactical. Strategic asset
allocation involves setting target allocations for different asset classes based on an investor's long-term
goals and risk tolerance. Tactical asset allocation involves making short-term adjustments to the portfolio
based on market conditions or changes in the investor's goals or risk tolerance.

The benefits of asset allocation include reducing portfolio risk through diversification and potentially
improving returns through exposure to different asset classes. However, asset allocation does not
guarantee a profit or protect against losses, and investors should carefully consider their investment
objectives, risk tolerance, and time horizon before making asset allocation decisions.

In conclusion, asset allocation is a critical investment decision that involves dividing a portfolio among
different asset classes to balance risk and return. Asset allocation decisions are influenced by several
factors, including an investor's risk tolerance, investment goals, time horizon, and market conditions.
Strategic and tactical asset allocation are two main approaches to asset allocation, each with its
advantages and disadvantages. Investors should carefully consider their investment objectives, risk
tolerance, and time horizon before making asset allocation decisions.