Asset Allocation: What It Is, How It Works And What Strategy Is Best For You
Hanna Kielar4-Minute Read
February 03, 2022
Asset allocation is a crucial consideration for anyone saving and investing their money. Investors often use asset allocation in order to keep their funds diversified. This means risk is minimized if only one investment declines due to market conditions, because there are multiple types of assets with differing returns and risk that have also been invested in. Let’s take a look at what asset allocation is, and what to consider before taking on this investment strategy.
What Is Asset Allocation?
Asset allocation is an investment strategy where investments are divided among different asset types, including stocks and bonds. Then, the percentage going toward each investment is adjusted, often periodically. The allocation and strategy that works best for you will depend on a number of factors, including your money goals and risk tolerance.
Diversification Vs. Asset Allocation
The goal of diversification is to avoid putting all of your funds into a single investment. For example, say you invest in a single stock from a single company. One way to diversify would be to buy additional stocks from multiple companies of varying risk. This would minimize the overall risk because if one stock declines in value, other investments can make up for it. Asset allocation, on the other hand, is an avenue to diversification because the strategy is not only to simply have multiple investments, but to have different types of assets within the investments as well.
What Are The 3 Major Asset Types?
Before diving into the strategies you can use for asset allocation, let’s break down the different types of assets you can invest in. Three major asset types to consider are stocks, bonds and cash.
A stock is when you buy a small portion or a “share” of another company. The idea behind the benefits of buying stock is that as the value of the company grows, so does the stock. This type of asset can be bought and sold on the stock market, and you may desire to change the allocation by buying new stocks or increasing the amount of shares in an existing stock.
Bonds are essentially loans an investor gives to a company or entity that gets paid back to them over time with interest. While these are often considered a “safer” investment option, they often yield less return than stocks.
Cash or cash equivalents, such as savings account deposits and certificates of deposit (CD), offer the safest investment but lowest return on investment when comparing the three asset types. Cash and cash equivalents are generally safe, however the greatest concern is inflation outpacing investments over time.
Types Of Asset Allocation Strategies
There are a number of asset allocation strategies that can be used to benefit your specific goals. Let’s take a look at a few allocation strategies; tactical, strategic, insured and integrated.
Tactical Asset Allocation
Tactical asset allocation is an active approach to asset allocation that involves shifting the percentage of allocation based on unusual market conditions or strong opportunities. This strategy focuses on the short-term, so it provides a lot of flexibility, but may not be sustainable for those looking for a more passive long-term approach.
Strategic Asset Allocation
Strategic asset allocation is considered a more “hands-off” approach to asset allocation. The allocation is set based on your risk tolerance, and the portfolio is simply rebalanced periodically. This strategy is seen as best for new investors investing for the long-term.
Insured Asset Allocation
Insured asset allocation is a strategy in which you actively manage your portfolio to increase its value, and invest in risk-free assets should that value begin to drop. Insured asset allocation is a great strategy for financially-savvy but risk-averse investors, as it requires active management of your portfolio, but ensures those funds don’t dramatically decline.
Integrated Asset Allocation
Integrated asset allocations take both economic expectations and the investor’s risk tolerance. Unlike other asset allocation models, integrated asset allocation strongly considers the risk involved in the asset mix.
Factors To Consider Before Allocating Your Assets
Before allocating (or reallocating) your assets, it’s important to look at your personal factors to assess how best to go about it. Some factors you’ll want to consider include your age, risk tolerance and current assets.
Money goals can include anything from retirement plans to buying a house. Your money goals can inform the assets you want to invest in. For example, a 401(k) is often used for retirement and may even have an opportunity for matching contributions from your employer.
Your age can determine what money goals you’re after, and therefore how proactive and aggressive you should be with your investments. For example, if you’re nearing retirement age and looking to use your investments to fund your retirement, a less risky investment that safeguards your current portfolio may be more beneficial to you. However, if you’re younger and looking to keep your investments long-term, a riskier portfolio might be in your favor. That’s why it’s so important to consider your short and long-term goals.
Your Risk Tolerance
Risk tolerance may be influenced by your age and money goals, but should still be looked at separately. If your money goals and age lend for a riskier investment, but you’re unwilling to take drastic measures, a more conservative approach may be the best choice for you.
Your Current Assets
You may already have an investment in multiple assets through a mutual fund. However, taking a close look into each investment and doing market research will prove beneficial. Even if no assets are sold or added, your decision for how to allocate them may change.
The Bottom Line: Do Your Research Before Reallocating Your Assets
Asset allocation is an investment strategy where funds are divided and strategically diversified. There are several types of assets (stocks, bonds and cash) as well as several specific strategies and considerations to think about before moving forward. Still not sure where to start? Read more about how to begin your journey to long-term investment and get started today.
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