Asset Allocation

Asset allocation is the distribution of investment funds among different classes of assets. The purpose of asset allocation is to assign funds to a combination of asset classes that maximizes return with the least risk. By their very nature, classes of asset and subcategories within asset classes have their own characteristics and respond to changes in the market environment differently. For example, one asset subcategory may experience a low return while at the same time another asset subcategory experiences a high return. A few months later, the situation may be reversed, with the formerly low-performing subcategory having higher returns. Creating an asset portfolio with a combination of different types of assets helps to balance the portfolio and allows it to withstand fluctuations in the market.

The decision on how to allocate investment funds is based on the investor’s goals, risk tolerance, and time horizon. Other factors that play a role include market conditions, inflation, and available capital.

Background

All investors are faced with the question of where to put their investment funds. For some investors, the choice will be easy: they are highly risk-averse and want to ensure they do not lose any money. For these investors, investments are intended primarily to protect their assets rather than generate substantial income. Cash or cash equivalents would be a good class of assets to meet their financial goals and risk tolerance. Other investors want to generate as much income as possible. For these investors, stocks could provide high returns and allow them to meet their goals.

For most investors, decisions about where to allocate investment funds are more complex than these examples and are based on several factors. The first factor to consider is one’s financial goals. For many, investment goals are to create a retirement fund such as an IRA. For others, goals may be for a specific purpose prior to retirement, such as building a fund for college expenses, a house, or other real property.

The financial goal determines the time horizon, or period of time in which funds are invested. Individuals who start investing for a specific purpose long before they need those funds have long time horizons. An example is parents of a newborn child who invest funds for their child’s college expenses shortly after the child’s birth. Individuals who start to invest funds closer to the time they need those funds have a short time horizon. An example is a teenager who decides in the middle of her junior year of high school to invest money for her college tuition.

The next factor that determines how to allocate one’s investment funds is risk tolerance. Individuals who have a high tolerance for risk are willing to take chances and accept the possibility of losing money in exchange for the possibility of high returns. They are willing to invest in asset classes that have the highest risk and potential for the highest returns. Individuals with low risk tolerance do not want to lose any of their invested funds. Thus, they typically invest in asset classes that have little, if any, risk. These asset classes also have the lowest return.

Other investors fall between these two risk extremes. They may be willing to take some risks with the hope of generating higher returns, but they are unwilling to gamble all of their investment funds on the riskiest investments.

The amount of time from when an investor invests money and the time when the money is needed is the time horizon. For example, individuals who start to save for retirement in their twenties have many years to build up their retirement funds and therefore have a long time horizon. Individuals who start to save for their retirement five years before they need those funds have a short time horizon.

The time horizon often influences how an investor allocates investment funds because it determines how aggressive or conservative the investments need to be. Investors with a long time horizon can be more aggressive, assuming they have at least a moderate risk tolerance, than investors who need the investment funds within a short period.

Investors typically allocate investment funds based on a combination of these factors. For example, an investor saving for retirement who has a moderate risk tolerance and twenty years before retirement may allocate some of his or her investment funds to high-risk stocks and some to moderate-risk bonds. In comparison, a risk-averse investor saving for retirement who also has twenty years before retirement may decide to invest all of the investment funds in different subcategories of stocks.

Overview

The main classes of assets and investments are stocks (or equities), bonds (or fixed income), and cash or cash equivalents. Other classes include real estate, options, collectibles, and precious metals.

A stock is a share of ownership in a company. Stockholders earn dividends based on the company’s earnings. If a company grows, the value of the stock increases. If a company goes bankrupt or out of business, the stock loses value and may become worthless. Stocks have the greatest potential for high returns and the highest risk for losses.

A bond is a loan to a company, municipality, or government. The investor is the lender, just like a bank, and the recipient promises to pay the loan back with interest. Federally-issued bonds generally are a safe investment because they are backed by the federal government. Examples include Treasury bills and savings bonds. Another type of government bond is the municipal bond, which is issued by a state or local government. Their safety depends on the credit worthiness of the issuer. A bond issued by city government with a high credit rating is safer than one issued by a local government with a low credit rating. Some of these bonds may be insured. Government bonds tend to have lower returns than stocks. Corporations also issue bonds. The risk involved with these bonds is comparable to stocks, with the potential for high returns or losses.

Another type of bond is a high-yield or junk bond. These are high-risk bonds issued by corporations with low credit ratings. They typically have higher yields than other types of bonds, but they carry a very high risk of default.

Cash or cash equivalents are cash funds in money market and savings accounts as well as certificates of deposit. Investments in cash equivalents are low or no-risk and have the lowest returns.

Stocks and securities are often subcategorized based on their location, industry or issuer, and company size. One type of subcategory is the asset’s division, which is characterized by its location: domestic, international, and global. For US investors, domestic means securities or stocks from financial markets in the United States; international are those from financial markets in other countries; and global are those that arise from financial markets in both the United States and other countries. Location is further subdivided by the state of development of the economy in which the financial market is located, such as developed economy, developing economy, or emerging economy.

Sector describes the segment of the economy of the asset. Examples include retail, energy, technology, and finance. Sectors are further categorized by specific industry type, such as gas and oil for the energy sector.

Stocks are also grouped by market capitalization, or company size. For example, a small cap describes a company with market capitalization of less than $2 billion. A mid cap describes a company with market capitalization between $2 and 10 billion, and a large cap describes a company with market capitalization over $10 billion.

Most individuals seek to create an investment portfolio that balances the risks and rewards based on their tolerance for risk and the time horizon before they need those funds. In general, most financial advisers recommend that investors who have a long time horizon and some risk tolerance maintain an aggressive portfolio and those who have a short time horizon or low risk tolerance maintain a more conservative portfolio.

An aggressive portfolio typically has a higher percentage of stocks than bonds and cash, which allows for the greatest gains but with high risk. A conservative portfolio has a higher percentage of cash than stocks and bonds, which has low gains but minimal risk. Portfolios between these two extremes consist of a mix of asset classes, with varying percentages of each asset class.

Financial advisers’ recommendations about how often investors should change their asset allocations are varied. Some financial advisers recommend that individuals review their investments periodically, such as every six or twelve months, and reallocate investment funds across classes of assets to meet the investor’s goals. For example, if the stock market is volatile, the investor may choose to move some investment funds to a different asset class. Other financial advisers recommend that individuals only adjust their allocations when substantial changes cause a portfolio to deviate from its original asset mix. For example, a portfolio originally may have a mix of 40 percent stocks, 30 percent bonds, and 30 percent cash. Over time, one category may grow or shrink and subsequently change the distribution percentages of asset categories. This would then necessitate a rebalance of the portfolio by buying or selling investments to return to the original asset allocation mix.

Most advisers recommend that individuals adjust their allocations as they approach the time they want to use investment funds. For example, a thirty-five-year-old investor may have a high percentage of investment funds in stocks and keeps the same percentage of investment funds in stocks for the next twenty years, despite fluctuations in the performance of the individual stocks. When that investor turns fifty-five and begins to plan for retirement at age sixty-five, investments might be reallocated among bonds and money market accounts.

Bibliography

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