Asset allocation (and diversification) are terms that gets used frequently when planning your finances and investments so it’s a great idea to have some idea of what they mean and how they might apply to you – even if you don’t own any investments at all!
“Your Investment plan is more important than your actual investments.”
— Rami Sethi, I Will Teach You To Be Rich
What is Asset Allocation?
Asset allocation is an investment strategy where you allocate your investments across several different asset classes, such as stocks, mutual funds, UITFs, money market securities, cash savings, real estate properties etc. In this strategy, how you divide your investment portfolio among the asset classes will depend on what works best for you at any given point in your life, on your time horizon and your ability to tolerate risk. You typically invest in stocks for long-term higher returns, bonds to reduce your overall risk and to earn income, and cash for near-term expenses. The goal of asset allocation is to balance risk and maximize return across your entire investment portfolio.
What is Diversification?
Diversification means that you invest in many different types of asset classes in order to reduce your risk. In order to be diversified, your investment portfolio needs to be spread across many different asset classes. If you hold just one type of investment and it performs badly, you could lose all of your money. If you hold a diversified portfolio with a variety of different investments, it’s much less likely that all of your investments will perform badly at the same time. The profits you earn on the investments that perform well offset the losses on those that perform poorly.
How to Choose an Asset Allocation Plan
Your tolerance for investment risk is unique, as is each of your financial goals, so you have to choose an asset allocation plan that suits both the level of risk you want to take and your goals. In terms of investing in the market, your asset classes typically fall into three categories: equities (stocks), bonds (fixed income investments), and cash. Each category has subcategories, too. Some of the subcategories are: mutual funds, UITFs, and money market fund. In our next few post, I shall tackle these asset classes in detail and how you can start investing in them.
Note: It’s important to have an emergency savings fund in place before you invest. Also, create a cash reserve of low-risk low-return investments to cover your regular expenses for at least 3 to 6 months and place them in safe choices like savings accounts, money market accounts and short-term bonds. Saving for regular expenses and emergencies protects you from redeeming your investments at a loss.
Asset allocation is a personal preference. Only you can decide on it. Here are a two options on how to allocate your investments.
Option 1: The 100 Rule
One rule of thumb that some people follow is this: Subtract your age from the number 100, and that’s the percentage of your portfolio that you should keep in stocks. The rest can be invested in bonds and other “safe” investments such as money market funds. For example, if you’re 35 years old, you should keep 65% of your portfolio in stocks. If you’re 60 years old, you should keep 30% of your portfolio in stocks.
That doesn’t mean you immediately put that much in it. This percentage can be spread across a period, starting with a small percentage and gradually increasing it as you become more comfortable about it.
Note: With people living longer and longer, many financial planners are now recommending that the rule should be closer to 110 or 120 minus your age. That’s because if you need to make your money last longer, you’ll need the extra growth that stocks can provide.
Option 2: Asset Allocation based on Your Investment Personality
Have you taken the What’s Your Investment Personality? test? If you did, using your investment personality, you can determine the asset allocation that best suits you.
A conservative portfolio has very low risk and very low rate of return. The main goal of a conservative portfolio is to protect the principal value of your portfolio (the money you originally invested) and (not to grow it). Usually, this is reserved for people who will need the money soon and who are older (think near retirement).
Moderately Conservative Portfolio
A moderately conservative portfolio is ideal for someone whose goal is to preserve a large portion of the portfolio’s total value, but is willing to take on a higher amount of risk to get some inflation protection. This is less conservative that the most conservative, but still conservative.
A moderate portfolio is often referred to as “balanced portfolios” since the asset allocations is divided almost equally between fixed-income securities and equities in order to provide a balance of growth and income. This strategy is best for investors with a longer time horizon (generally more than 5 years) and a medium level of risk tolerance.
Moderately Aggressive Portfolio
A moderately aggressive portfolio is best for long-term investors who want growth potential and are prepared to invest for 5 to 10 years. In this risk profile, investors can tolerate a fair level of risk in anticipation of possible higher returns. To provide some diversification, investors usually add some fixed-income securities to a portfolio that consist almost entirely of equities.
An aggressive portfolio has the highest risk and the highest potential rate of return. The main goal is to aggressively grow your investments over a long time horizon. You can tolerate substantial fluctuations in the value of your investment in the short-term in anticipation of the highest possible return over a period of 10 years or more. Usually, this is reserved for people who won’t need the money soon and who are younger (think 29 year old who is investing for retirement at age 60).
Maintaining Your Allocated Portfolio
Once you’ve decided on a specific asset allocation strategy, you need to maintain that. As the market moves, so will your investments. For example, you started with a moderately conservative portfolio, then the value of the equity portion increased significantly during the year, suddenly giving you an equity heavy portfolio. This makes the portfolio more like that of an investor practicing a balanced portfolio strategy, which is higher risk!
At a glance, there’s more weight in equities than it had before. One option is to just leave it as it is. Or you’ll have to ‘rebalance’ your portfolio to maintain the percentage of asset classes that you desire. 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, time horizon or tolerance for risk has changed.
Note: The closer you are to your financial objectives, the less aggressive you need to be, and start moving your investments to less riskier investments.
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