The Role of Asset Allocation In A Healthy Portfolio

Asset allocation is a phrase that refers to how you allocate your funds into different classes of investments. It is a simple concept, but the way you allocate your assets may have big impact on the overall performance of your portfolio.

Investment Classes  

There are three basic type of public investments:

  • Equities or Stocks:

Equities or stocks are an investment class where the asset you own is a portion of the company itself. The price any given equity may change, although the “market” has gained 7% to 10% a year on average overall. (Past performance is not a guarantee of future performance.) Investors attempt to sell equities for a higher price than they paid for them, sometimes by holding the stock for a long time and sometimes by selling the stock quickly if the price rises.

  • Fixed-Income

Fixed-Income investments bring in income for the time that you hold them. An example of a fixed-income asset is a bond which pays the stated yield twice a year until it matures for the original face value. The value of bonds fluctuates and some bonds are more stable than others, offering investors a range of conservative to aggressive strategies.

  • Cash Equivalents 

Cash equivalents are assets that offer easy access. It is easy to purchase these investments, for example, savings accounts or a money market fund. Although cash equivalents usually offer a low interest rate, the reason to keep them is to have fast, easy access to money.

Asset Allocation Formulas

Many professionals who give advice on asset allocation claim to have a magic formula that anyone can follow in order to understand what their asset allocation should be. Commonly, these formulas begin with the age of the investor, which allows the formula to make assumptions about how aggressive the investor can “afford” to be.

The idea is that a younger investor has potentially many years ahead of them to earn money compared to an investor closer to retirement age. Therefore, according to the theory, a young investor can take a more aggressive investment stance while an older investor might want to be more conservative. The more aggressive the investment strategy, the higher the potential to lose money. The formula hinges on the assumption that younger people can more easily recover from a loss than older people.

However, generalized formulas do not take unique situations into perspective. In fact, it is fairly easy to imagine, for example, a young investor requiring a more accessible and conservative portfolio compared to an older investor who may not have such a great need for access to cash. The truth is that deciding your asset allocation means understanding your specific needs, goals, objectives and financial situation in order to determine the best asset allocation for you. 

Keep Asset Allocation at the Forefront

To determine your asset allocation, you will need to examine your financial situation carefully. Consider how much of your portfolio you may need to be able to access quickly, what kind of risk you are comfortable with and what your long- and short-term financial goals are. These are the core questions to determine your asset allocation, which is crucial to any investment strategy.