You can think of Asset Allocation like slicing up a pie. The pie is your investment portfolio, and the slices are made up of different forms of investments such as cash and various securities. These might include such investments as stocks, bonds, mutual funds, ETFs, REITs, private equity, and cash equivalents. The idea here is to diversify your investments to reduce risk because each type of securities investment has a different risk profile and correlation to the others in the portfolio.
Reasons for Asset Allocation
For instance, when bonds fall in value, stocks often rise at the same time. By having both in your portfolio, this can help to reduce risk by compensating for the loss in one with the gain in the other. Likewise, when the stock market begins to fall, the real estate market might be climbing. By diversifying across different types of investments, you can help to fortify your portfolio, so it is better able to cope with changing market conditions.
Asset Allocation: Slicing Up the Portfolio Pie
The percentages of your portfolio that are allocated to each type of investment will be determined by your asset allocation model. The asset allocation model you use will typically be designed to fit well with your risk tolerance preferences and financial goals. You will divide your portfolio up into asset classes to fit with these goals and tolerances.
Allocation by Investment Type
Additionally, each asset class can further be subdivided up into individual investments to diversify it further and continue to reduce risk while maximizing returns within your acceptable risk parameters.
Allocation By Market Sector
For example, if your asset manager recommends an allocation of 50% to be given to stocks, they may choose to further subdivide that across several industries such as technology, pharmaceuticals, consumer retail, etc. They may also choose to allocate according to market cap, with varying allocations going to large-cap, mid-cap, and small-cap companies.
Asset Allocation Model Reflects Need
Throughout many decades of history, it has been more profitable to invest in corporate stocks than to invest in bonds. However, there is more than one reason to invest, and because of that, there are reasons to invest in each.
For example, a retiree who is depending on the performance of their investment portfolio to provide a day-to-day income might be unwise to invest it in stocks which are exposed to constant market fluctuations and need to be sold to provide income. Bonds, on the other hand, provide income while you still hold them and are not affected in the same way by market fluctuations, making them a much more stable and lower risk investment which is more appropriate to the needs of a post-retirement portfolio.
On the other hand, a young professional who is fresh out of college and has just begun and long career in a chosen field may be better served by a more aggressive allocation in favor of corporate stocks. The younger person will have adequate time to recover from market fluctuations, and as a result, will be able to grow their net worth as they approach retirement. This net worth will be necessary later on in life when they progressively re-allocate to shift gradually away from stocks and towards bonds as they slowly approach retirement age. Finally, when they end up at their target retirement date, they may choose to shift their asset allocation towards bonds almost entirely, like in the previous example, to stabilize their net worth and income for the long term.
Types of Asset Allocation Model
Generally speaking, the types of asset allocation models fall into four different categories: growth, income, preservation of capital, or balanced.
1. Growth models are typically used by those who are many years away from their target retirement date and have ample time to wait out market fluctuations. Their objective is to grow their net worth as much as possible within their risk tolerances during the time frame between the present day and their retirement date. The goal of these models is to grow long term wealth by increasing net worth.
One notable aspect of growth portfolios is that they are typically grown not only through the growth of the assets within the portfolio, but also grown by adding capital to them regularly through regular deposits. If the stock market is on a bull run, the growth portfolio model will benefit greatly and achieve maximum growth. However, in a bear market, the portfolio’s value will also take the biggest hit relative to other asset allocation models.
2. Income portfolios are often used by retirees who need a stable, predictable income from their portfolio, and who are more interested in preserving their capital than in growing it. They will usually contain a large allocation of high-quality income-producing bonds or investment-grade debt obligations such as those from blue-chip companies, rather than growth stocks. It might also contain Real Estate Investment Trust shares (REITs), or Treasury Notes.
Another type of account which might use an income model is that of a young widow who is living off of her deceased husband’s life insurance policy payments. She cannot afford to risk her money in a growth account and needs reliable income so that she would be served by an income portfolio allocation.
3. Preservation of capital is temporary models and used because the portfolio owner needs to maintain quick access to their capital shortly. They may not wish to expose their portfolio to the necessary market fluctuations of growth models, or the lack of liquidity created by income models. The preservation of capital model might use cash, cash equivalents such as money market accounts, treasuries, or commercial paper. These accounts are often used temporarily because they miss out on most of the benefits of the other types of asset allocation models in favor of prioritizing the preservation of capital instead.
4. Balanced asset allocation is mix between the Growth and Income models. Many people prefer the balanced portfolio allocation model because of the emotional advantages. Yes, you read that right. You see, when you invest in a growth model, you will need to witness fluctuations in your portfolio and be ok with them. Sometimes they can be quite dramatic and scary, and it can be very tempting to sell at the bottom of the market or after downturns. However, this would make you lose capital. On the other hand, income portfolios, while less risky and providing more stability, can be quite boring.
You will need to watch the market make big runs where you could have experienced large gains in net worth but are missing out because of your conservative asset allocation in income-producing investments. A balanced portfolio addresses these issues by providing a combination of growth with risk and income with stability in the same portfolio. This way, your portfolio can still experience income while the growth side is in decline, and you won’t need to miss out on opportunities afforded by market growth.
Asset Allocations Change Over Time
It is important to note that you will not likely choose any one of these models for the duration of your portfolio but will probably switch gradually from one to another over time, and then from that one perhaps on to yet another. Each asset allocation model serves its purposes, and it will be up to you and your investment advisor to determine which asset allocation model is right for you.
Is there a particular model you prefer for your current stage in life? Feel free to share with others in the comments below!