What is asset allocation?

Summary 

What is asset allocation? 

If you’ve been looking at investment options, you probably encountered a few new terms that leave you asking questions such as, “What is asset allocation?” To put it simply, asset allocation is how an investor divides their portfolio among various assets. 

These assets can include cash and its equivalents, equities, and fixed-income assets. Most investors approach asset allocation by trying to balance rewards and risks based on the investment horizon, financial goals, and risk tolerance. 

How does asset allocation work? 

There is no one-size-fits-all asset allocation formula. If you were to take the common approach, you would start by deciding how to divide your investments among bonds, cash and cash equivalents, and stocks.  

Next, you would select individual securities within an asset class. Your investment results largely depend on these decisions.  

The idea is to base your choice of asset allocation on specific goals. For example, if you want to save for when you retire in a few decades’ time, you might invest most of your retirement account in stocks. Doing this gives you time to outlast short-term market fluctuations. However, if you want to save to buy a car in a year, you might take a conservative approach that sees you invest your savings in a mix of cash, short-term bonds, and certificates of deposit. 

How does asset allocation influence your investment portfolio?  

Various external factors, such as economic cycles or political events, can influence your asset allocation. This obviously will affect your investment portfolio. 

Most investors prefer growth-oriented assets such as stocks in markets with rising prices (bull markets). When prices are falling, such as during recessions or downturns, most investors prefer capital-preserving conservative investments such as cash equivalents or bonds. 

If external factors negatively impact your portfolio, you can rebalance it using asset allocation strategies. We’ll delve into a few of those below. 

What is a risk assessment, and why is it important for asset allocation? 

A risk assessment helps you understand your willingness and capacity to take on risk in your investments. It's vital for aligning your asset allocation with your comfort level and goals. 

If you aren’t comfortable investing in stocks, you might be more willing to invest in conservative asset classes even if you have a long-term investment horizon. There’s nothing wrong with this, as different investors have different strategies for allocation of funds and other assets. 

Many financial advisors recommend holding stocks for at least five years and choosing cash and money market accounts for goals you want to achieve in less than one year. They also recommend choosing bonds for goals that you want to achieve sometime between one and five years from now. 

That said, age can influence asset allocation. Younger investors may tolerate more risk, while older individuals may seek a more conservative allocation to preserve wealth in retirement. A good rule of thumb is to subtract your age from 100 to determine what percentage you should invest in stocks. 

Can I achieve asset allocation through mutual funds and ETFs? 

Yes, you can. Many mutual funds and exchange-traded funds (ETFs) are designed to represent specific asset classes. This makes it easier for investors to implement asset allocation strategies. 

Can asset allocation change over time? 

Yes, asset allocation can and should change over time. You should periodically review and adjust your allocation of funds and other assets, adapting to changes in your financial situation, goals, and market conditions. 

How does asset allocation differ from diversification? 

Diversification is the practice of spreading investments within each asset class. Asset allocation involves deciding how much of your portfolio should be in each asset class. 

What are asset allocation strategies? 

Even though most investors tend to follow the same basic approach, they use multiple asset allocation strategies in the hope of achieving their financial goals. A good age-related approach is to invest more in stocks when you’re younger and less likely to need access to the capital you invested. 

However, something other than this approach might work better for you. This is where dynamic, insured, and tactical allocation strategies come into play. Explore some of them below. 

How can external factors affect asset allocation? 

A variety of external factors can affect asset allocation. Common factors include: 

What is dynamic asset allocation? 

Dynamic asset allocation is a common strategy for allocating assets. This strategy adjusts the mix of asset classes frequently in response to market conditions. In most cases, you add to positions in the best-performing assets while reducing positions in the worst-performing asset classes.  

For example, global equities enter a six-month bear market (prices fall). Using this strategy, you might decide to increase your portfolio’s fixed-interest assets and reduce its equity holdings to reduce risk. With an equities-heavy portfolio, you could sell some equity holdings and purchase bonds instead. 

What is iInsured asset allocation? 

Insured asset allocation is another common strategy among investors. This strategy sees you establish a base portfolio value. You should keep your portfolio from dropping below this base value.  

You can manage your investment portfolio actively as long as you’re seeing returns above the base. You can rely on analytical research, experience, forecasts, and judgment when deciding which securities to hold, sell, and buy to increase your portfolio value. If your portfolio drops to or below the base value, you can invest in risk-free assets such as T-bills and other Treasuries, fixing your base value. It would be best to speak to a regulated financial advisor about reallocating assets. 

What is tactical asset allocation? 

If you start to find that a strategic allocation strategy becomes too rigid over time, you can occasionally use short-term tactical asset allocation. Doing this allows you to leverage unexpected investment opportunities and include a market-timing element in your investment portfolio.  

After achieving the short-term profits that you wanted, you can return to the original overall strategic asset mix. For example, your strategic allocation is 45% bonds, 45% stocks, and 10% cash. If the yield curve inverts, indicating a recession, you can use tactical allocation and adjust your portfolio’s asset class to 70% bonds, 20% stocks, and 10% cash. 

What assets should I invest in?  

The allocation of funds and other assets is one of the most important aspects of managing your investment portfolio effectively. You must understand what asset allocation is and how external factors can affect your investments and decisions. It’s also important to have proper risk assessments and to use various strategies to create the most favorable conditions as you aim to achieve your goals over time.  

Speak to a financial advisor to learn more about asset allocation and for expert financial advice on what assets to invest in.