Asset allocation is a strategy and process to determine where to keep the money to grow in the market. It strives to counterbalance risk and reward by apportioning a portfolio’s assets.
The assets are apportioned in line with an individual’s financial plans, risk tolerance, and investment horizon. The three main asset classes are fixed-income, equities, and cash (and equivalents). Each of these asset classes has distinct levels of risk and return and will have a unique behavior over time.
Strategic asset allocation
Investors might involve in different asset allocations for various goals. Let’s take the example of someone wanting to buy a new car. The person — setting aside funds for a vehicle for the following year — could invest their vehicle purchase fund in an extremely safe combination of cash, certificates of deposit (CDs), or short-term bonds. A person who is setting aside savings for retirement might be used only after many years; thus, the person might contribute to an individual retirement account (IRA), or also might invest in stocks because they have a great deal of time and need not worry about short-term fluctuations in a volatile market.
Risk tolerance plays a vital role
One who doesn’t want to take the risk of investing in stocks might place the cash in a more safe allocation even if they have long-term goals.
Age-based
As a general rule, stocks are suggested only if the individual plans to hold them for five years or longer.
Cash and money market accounts are better for a year or less.
Bonds are in the middle
As people near retirement age, portfolios for the most part should move to a more safe and conservative asset allocation to safeguard assets without any risk.
What is an asset allocation fund?
An asset allocation fund offers investors a diversified portfolio of investments with various different asset classes. The “asset allocation” of the fund could be fixed or even varying with a mixture of asset classes — that means it may hold fixed percentages or be permitted to go overweight, depending on market conditions.
Accomplishing asset allocation through life-cycle funds
Asset allocation mutual funds (also known as life-cycle or target-date) try their best to offer investors portfolio structures that specifically address the investor’s age, risk tolerance, and financial goals with a suitable apportionment of asset classes. However, some financial experts don’t endorse this generic, standardized solution for allocating portfolio assets because they believe that individual investors require specific, individual solutions.
Target-date fund
The Vanguard Target Retirement 2030 Fund is an example of a target-date fund. These funds slowly lower the risk in the portfolios as they near the target date. They typically cut the more risky stocks and add safer bonds to conserve the nest egg. As of January 31, 2022, The Vanguard 2030 fund — which was set up for people who might retire between 2028 and 2032 — had an allocation of 65% stock/35% bond. When the year 2030 nears, the fund would slowly turn to a conservative combination to achieve better capital preservation and minimize risk.
Why is asset allocation important?
Asset allocation is a significantly crucial part of creating and balancing the investment portfolio. Moreover, asset allocation helps in visualizing and gaining overall returns — definitely more than picking individual stocks.
Coming up with a suitable mix of stocks, bonds, cash, and real estate in the portfolio is not a one-time selection but a dynamic process — the asset mix change and vary according to the goals over time.
Let’s summarize
Nearly all financial professionals conclude that asset allocation of individual securities in which assets are allocated in stocks, bonds, and cash (and equivalents) will be the principal determinants of your investment results.
