What is Asset Allocation?
Asset allocation is an investment strategy that is used to choose among various asset classes such as stocks, bonds, commodities, foreign currencies, real estate, annuities and life insurance, and high value collectibles including precious metals.
Asset allocation as a way of investing is an important part of a person’s financial planning process that primarily concerns the very relationship of an investment portfolio’s risk and return. Different asset classes offer different risks and returns as long as their performances are not perfectly correlated (if they go up and down in the same market conditions). Asset allocation reduces the volatility of investment results when not all investments in the portfolio rise and fall at the same time.
How is Asset Allocation Related to Investing?
In essence, investing is about growing capital over time.
But any investment’s future performance is uncertain and likely experiences fluctuations in price or value from time to time. Such potential investment risks are not uncommon in commodities, foreign exchanges, and certainly in stocks as well. To mitigate a particular type of risk uncertainty in an individual investment, derivative hedging, such as futures, options and swaps, has been widely used to smooth out expected future price fluctuations. Hedging eliminates the possibility of both incurring bigger losses and reaping in higher returns, but in exchange, helps achieve a level of certainty in investment results. Comparable to risk management of individual investments, asset allocation is a way of hedging in portfolio situations. Each investment class serves as a hedge for the other investment class. As a result, when one investment loses, the other gains and total investment results of the entire portfolio are smoothed out to reach a give level of expected return.
Why is Asset Allocation Important?
Asset allocation can be considered as a form of passive investment management.
Once investment funds are allocated among asset classes based on the set percentage or weights, it is important for average investors to stick with the plan, except periodic portfolio adjustments. Active investing of buying and selling by jumping from one asset to another not only would require time, resources and expertise, but also might end up with worse results than following a consistent plan. The most representative of passive management is index funds investing and its popularity has risen steadily. Index funds use the same asset allocation idea and consist of a portfolio of different securities that either replicates or resembles an existing, known market index or follows an fund’s own proprietary index. Index investing, as well as asset allocation method, ensures that the worst investment results never happen.
How can Asset Allocation be Done?
The process of asset allocation can be summarized as: define investment goals with the relative risk tolerance, choose the range of diversification, and assign weights to each asset class. Age, expected future major expenditures, the level of future earned income, etc… are factors to consider when trying to define investment goals and decide how much risk to take on. In addition to different asset classes, asset allocation also concerns the diversification of investment style particularly in equity investments, a major asset class. Choose among large, mid, and small caps or growth, value and blend. Finally, based on the different rates of return on the chosen asset classes, assign multiple sets of weights to each asset class and compare the total weighted average rate of return under each set of weights with one another and against the expected investment return as defined in the investment goals.
To summarize – Asset Allocation deals with putting your investments in different asset classes to help spread out market risk. This helps smooth out the overall return of your portfolio over different market conditions.