Regardless of how far along you are in your investing journey, a crucial step is deciding how to allocate assets in your portfolio. The asset allocation you choose will significantly impact your investment results. Constructing a successful investment portfolio that maximizes returns while maintaining a balance of risk requires employing a strategy that fits your needs and aligns with your preferences.
Understanding Portfolio Allocation
Investment portfolios typically hold a variety of assets such as stocks, bonds, commodities, real estate, etc. Deciding on the proportional holdings of different assets within your portfolio is called portfolio allocation.
The key to determining the allocation that works best for you requires an understanding of your risk tolerance. This concept refers to the amount of loss you are comfortable accepting with your investments. Generally, the higher the risk, the higher the reward. An investor with a high-risk tolerance is prepared to risk losing more money for a higher reward. In contrast, a low-risk-tolerant investor tends to be more conservative and not as willing to lose their original investment.
Every asset carries a level of risk, varying from one asset to the other. Stocks tend to be riskier but have higher returns. Conversely, bonds are considered safer and may be a wiser choice during an economic downturn. Understanding the risk associated with each asset class and gauging this against your risk tolerance will help you determine the appropriate amount of each asset class for your portfolio. Asset allocation is a way to align your portfolio’s risk level with your risk tolerance.
Many investors choose to diversify their holdings to balance the risk associated with each asset class against their risk tolerance. Diversification balances your risk-reward profile, as spreading your assets across various investments can mitigate the risk associated with any individual asset.
While important, risk tolerance is not the only factor to consider when determining your asset allocation. Other factors to consider include your investment goals (short-term vs long-term), timeline (age and retirement date), and market conditions. Along with risk tolerance, these factors all play an important role in deciding the distribution of assets in your portfolio.
The ideal asset allocation is unique for each investor, and devising the optimal asset allocation for your portfolio can be challenging. I will discuss some common strategies you may find helpful when deciding on and maintaining your optimal asset allocation.
Asset Allocation Strategies
Strategic Asset Allocation
Strategic asset allocation involves setting and maintaining a mix of target asset allocations based on the anticipated return of each asset and periodically rebalancing when the portfolio deviates too much from the original targets. Investors employing this strategy choose the proportional amount of each asset (for example, 60% stock, 30% bonds, 10% cash) based on their risk tolerance, timeline, and goals. This allocation method is a long-term strategy that allows investors to take a more passive investment approach when determining their asset allocation since it does not regularly consider market conditions or trends.
This option may be advantageous for some investors as it is straightforward and does not require expertise in market conditions or trends. A shortfall of strategic asset allocation is oftentimes higher-performing assets are sold to buy more lower-performing ones in an effort to rebalance the portfolio back to the target allocation.
Tactical Asset Allocation
This strategy involves actively managing your portfolio to take advantage of market trends and conditions. Like with strategic asset allocation, investors will set target allocations for each asset class, but instead of keeping this allocation constant, they will make short-term adjustments in order to take advantage of market opportunities. The change in allocation is only done for a short period of time and will revert to the original allocation once the opportunities are no longer available.
This type of strategy demands a certain level of understanding of markets and trends to make appropriate and timely allocation shifts. If market predictions are correct, your portfolio can benefit from this type of strategy. However, it can be risky if predictions are wrong.
Dynamic Asset Allocation
This strategy is another active management one that involves making allocation shifts based on market conditions and trends. Unlike tactical asset allocation, dynamic asset allocation does not have a target allocation for each asset class. Instead, the portfolio manager makes changes to the portfolio as they see fit. Employing this strategy successfully requires a certain level of expertise since shifts must be made contemporaneously with market trends and conditions.
An advantage to this strategy is that investors can reap the rewards of investing in the best-performing assets at the right times. However, it may result in higher transaction costs from continuous buying and selling of assets or higher fees for portfolio managers.
Insured Asset Allocation
When using the insured asset allocation strategy, an investor will set a base portfolio value under which it will not be allowed to dip. So long as the portfolio does not go below this value, the investor will actively manage the portfolio using forecasts and trends to make investment decisions and increase the return on investment as much as possible. If the portfolio does dip below the base value, the investor should shift the allocation to more risk-averse assets.
This strategy is best for risk-averse investors who like to have a particular portfolio value to make investments with. However, investors who need to sell assets to maintain the portfolio base may lose out on potential returns if that asset bounces back after being sold.
Choosing the Right Strategy
Deciding on an asset allocation strategy depends on your risk tolerance, investment goals, timeline, and expertise. A new investor with only basic financial knowledge may prefer strategic asset allocation since it is more of a passive investing strategy. Conversely, a more active investor with financial expertise may be more inclined to choose the tactic or dynamic investing strategies.
Choosing an asset allocation can be difficult for investors. Implementing an effective strategy can optimize your allocation and increase your returns.