Asset allocation is the modality of deploying an investment plan aimed at achieving the maximum risk/return profile by apportioning the proportion of each asset in an investment portfolio to match the investment profile of the investor.
The emphasis is made on the parameters that may be typical for the overall investment portfolio. Such a strategy has implications for organization structure that are diametrically opposed to those of an asset-based strategy.
Hence according to many of these financial gurus it is believed that a significant correlation between asset allocation and returns in an investment portfolio is possible.
Asset allocation is based on the premise that various assets react in various ways depending on the state of the market and the economy.
Another reason for asset allocation is based on the belief that there is no one period return on assets which are classified in different classes which therefore makes the risk reduction measurable through variation for a given level of expected return.
Portfolio diversification has been widely defined as one of the “only two things that you get for nothing in the whole arena of the investment business”.[2] Professional literature has described and expounded on the concept and advantages of asset allocation as well as the issues with active management.
Even if it is reduced when correlations are not perfect, it is usually predicted (either wholly or partly) statistically from data analyses for correlation and variance over some earlier period.
Similar to expectations for return, expectations of the cost of type two error are also usually derived. Investigations of these forecasting methods form an important scholarly line.
When such historical measures are applied to forecast future returns or risks using mean-variance optimization method of MPT portfolio selection models that embody modern portfolio theory the strategy is indeed forecasting future risks and returns using history.
Since there is no certainty of the continuation of these prior relations in the future a very important link between ‘’traditional asset allocation’’ is what has been categorized as ’’weak links” derived from MPT.
Factors Affecting Asset Allocation Decision
This sample identifies the key determinants that influence asset allocation decision as including the following.
At the time of investment decision, investors recognize the proportion that has to be invested in securities depending on the objectives, tolerance to risk and the time horizon of the investment.
1. Goal factors
Goal factors are individual needs to earn and obtain a specific level of return and or saving for a given purpose or want. Thus, goals direct investment and risk in a different manner.
2. Risk tolerance
Risk taking ability or risk appetite thus can be defined as the capacity coupled with willingness of an individual to lose a certain amount of the initial stock expected to be doubled in future.
For instance, risk-shy investors take their money out of portfolio and put it into safer investment alternatives.
While more aggressive investors put most of the investments with the hope of experiencing high returns. As a quick refresher, please read the section on risk and return.
3. Time horizon
The time horizon factor depends with the how long period that an investor is going to invest.
Sometimes this is true due to the time horizon of the investment and other at other times it is dependent on the objectives of the investment.
Likewise, risk tolerance varies depending on a given working capital cycle time horizon.
For instance,
a long-term investment plan may make an investor to invest in a risky or higher risk portfolio knowing well that the state of economy is unpredictable and may turn in the favor of an investor.
Short-term oriented investors may not invest in higher risk portfolios, however.
How Asset Allocation Works
Typically, financial consultants recommend that an investor will have to diversify their investment across different types of securities to lower the variability of portfolio. Such basic reasoning is what makes asset allocation common in portfolio management because you will always get differing results from the different classes of assets. Therefore, investors will be given a shield through which their investments will be protected from declining.
Example of Asset Allocation
Let’s assume Joe is working on a project that outlines the amount of money he wants to accumulate before pulling out from active business. Therefore, he needs to invest his $10,000 saving for a period of five years in the equity investment. Therefore, his financial advisor might recommend to Joe that he splits his portfolio into the three main asset classes at 50/40/10 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.
Strategies for Asset Allocation
When it comes to the investment asset management there is no restriction on how an investment can be made and what strategy is followed by the financial advisors. The two strategies, listed below, are used to effectively influence the investment decisions.
1. Age-based Asset Allocation
In this method the decision regarding investment is determined by the age of the investors. For this reason, most financial advisors encourage investors to use the difference between the age and 100 as the base for making the stock investment decision.
It all depends with the life span of the investor. The greater the length of life expectancy, the greater the proportion of funds invested in riskier activities including buying and selling of stocks.
Example
If taking the previous example, then it is assumed that Joe is currently 50 years old and the desire of his life is to retire at 60.
By applying the age-based investment strategy, his advisor might recommend him to invest in the stock to the tune of 50%, the rest into other products.
This is because if you subtract 50 years from 100000, which is a hundred-base value here, you will get a fifty and that represents him.
2. Life-cycle funds vary in their Asset Allocation
Within life-cycle fund allocation or targeted-date, an investor will define the return on investment (ROI) based on factors such as the investment goal, investor’s risk capable and age. Such portfolio organization structure is complex since questions arise about standardization.
More specifically, it has been found that every investor is different in some way along the three factors.
Example:
Assuming that Joe has 50/50 investment portfolio. Thus, for an investor with his tendency his risk tolerance against stock may increase to 15% after five years of time horizon.
He will therefore divest out of the 15% bond and reinvest the same in stocks. His new mix will be 65/35.
This ratio may continue to change over time based on the three factors: investment goals, the ability to take risk, and the age of an investor.
Examples of Other Strategies
1. The second policy is the constant-weight asset allocation.
The constant-weight asset allocation strategy is derived from the basic policy of the buy-and- hold. In other words, if the value of any stock declines, investors form a pool to purchase more of the stock.
But they buy a larger proportion when it rises in price level they buy a more proportionate amount.
The aim here is to see that the ratio does not go out of a tolerance level of the initial ratio by more than 5%.
2. Tactical Asset Allocation
The tactical asset allocation strategy responds to the problems that stem from strategic asset allocation connected to long-run investment policies.
Consequently, tactical asset allocation seeks to capture the short-term approach, which is involved in investment.
Therefore, it brings more flexibility that enable the coping with the market fluctuations so that the investors invest in better yielding assets.
3. Insured Asset Allocation
Strict adherent of the efficient frontier should therefore go for the insured asset allocation for the investment programs.
It involves determination of a minimum value for the assets out of which the portfolio is not supposed to fall. If it drops, the investor makes the required move to minimize the risk.
Otherwise, if they can get a value just slightly higher that the base asset value they can afford to buy, hold or even sell.
4. Dynamic Asset Allocation
The dynamic asset allocation is frequently used kind of investment approach. Through it, investors can also shift the proportion of their investment with the market frills and the ups and downs in the economy.
FAQs on Asset Allocation
1.What are the identifiable determinants of assets allocation?
Risk Tolerance: The general market volatility endurance tools and willingness.
Investment Horizon: The period within which goals concerning finance should be accomplished.
Financial Goals: Whether the goal is small, and the consumer wants to save up for a small purchase, or if the goal is large, and the consumer is saving up for something like retirement or to go back to college.
Market Conditions: There are correlations between the movements in the economy and performance of asset classes.
Liquidity Needs: They add that the often one thing which does is the necessity for readily available cash whereby these impacts on allocation.
2. What are the options in the several types of asset allocation methods?
Strategic Allocation: In this respect, a fixed tangible asset mix that is consistent with general long-term organizational objectives is called for.
Tactical Allocation: Flows or changing the mix but not in structurally, that is, in the short-run depending with the market situation.
Dynamic Allocation: Adjusting the portfolio frequently with regards to changes on the market…but
Target-Date Funds: Allowing automatic shifting in the allocation as the time horizon approaches.
3. What role does risk tolerance play in determining the diversification of investment?
Using the theory, aggressive investors may invest more in the risky and relevant assets such as shares more than the conservative investor who would prefer safer securities such as bonds or cash.
4. In simple words, can asset allocation strategy be considered as the same as diversification?
Asset allocation, it means where to invest, and diversification concerns how to invest in those areas.
5. Can changes in asset allocation occur over time?
Yes, this is true as an investor’s objective may change over time, his ability to take on risk or conditions of the market may change hence portfolio must change.
6. What are the types of assets that are put into allocation?
Stocks: For capital growth.
Bonds: For stable income.
Real Estate: Long-term appreciation and operational income are two of the most desirable characteristics of stocks.
Cash or Cash Equivalents: Liquidity and nil risk…
Alternative Investments: For instance, commodities or private equity for a portfolio purpose or generating earnings diversification.
7. What is balancing in portfolio?
Redistribution is the task of bringing the proportion of financial assets back to the initial levels after fluctuations have occurred that changed all the proportions.
8. How does an investor select the model for its assets mix?
Portfolio managers choose a model according to investor’s risk profile and investment objective – conservative, moderate or aggressive.