What is asset allocation?
Investors who want to limit risks and increase returns must consider composing their portfolios with instruments from various asset classes. Those classes would include types of investments that would vary in risks and returns, for example, stocks, commodities, real estate, cash equivalents, precious metals, mutual funds, stock indexes, private equity, cryptocurrencies, etc.
This spread of funds through diverse asset classes helps balance portfolios as assets from each category perform differently during different periods. For example, stocks that are considered a risk-on asset class will perform well when the economy is doing great, while bonds that are a risk-off asset class will underperform within the same period. When the underlying conditions in the economy change bonds rally and stocks fall.
Factors that determine asset allocation model
Your needs are one of the primary things to consider while constructing his allocation model. If you want to preserve their capital, you should consider putting most of your resources into bonds or low-risk stocks that pay dividends. If you expect to generate above-average returns, you would probably have a big chunk of their money put into small-cap stocks that historically tend to outperform such assets as bonds, real estate, or precious metals.
Another important factor is risk tolerance. The more risk-averse you are, the more conservative your portfolio will be. And vice versa, the greater your risk tolerance is, the riskier assets will comprise your portfolio.
Age is another critical determinant of how an individual will spread out his resources while determining what should be in his basket. A younger person will likely have a longer life expectancy, more significant risk tolerance, and a desire to create a nest egg for retirement. A middle-aged person will likely have a mixed portfolio that could be composed of both risky and conservative types of investments. And a person that is about to retire will likely have most of his funds in government bonds that are considered very safe or in dividend aristocrats, companies that have been paying dividends for 25 consecutive years.
Eventually, it all comes down to your risk tolerance. And based on that, you will choose what type of investment portfolio you want to create and what percentages of which assets would comprise it.
What types of portfolios are there?
As the asset allocation in any given portfolio depends on risk tolerance, all possible variations of portfolios will depend on the degree of risk you are willing to take. Therefore, portfolios will vary from very low risk or conservative to very high risk or aggressive. Let’s look at a few possible variations of the portfolios.
A conservative portfolio is a low risk. You would compose it by putting the bulk of your funds into government bonds (for example, German Bunds), U.S. Treasury notes, low-risk securities, such as bonds issued by large corporations. Most of these are also called fixed-income securities.
The portfolio’s target would be to preserve the initial value of your funds, which is why these types of portfolios are called capital preservation portfolios. The returns of this portfolio will probably lag behind inflation.
Although you try to avoid risk and such assets as stocks, you still may want to consider adding some 10% of your funds to the safest blue-chip stocks to mix up your portfolio a bit.
Medium risk portfolio
Medium-risk model portfolios, or balanced portfolios, are usually divided into equal portions between fixed-income securities and stocks. This type of model is meant to keep a balance between the growth of your portfolio and income. These portfolios are inherently riskier than conservative ones. They would have a time span of three to five years and are often reviewed and restructured depending on underlying market conditions. It is suitable for investors with moderate risk tolerance and expectations to keep up with inflation.
There is always some flexibility in the allocation model and the possibility of throwing in some other instruments that would take 10%-15% of the portfolio provided the diversification does not substantially increase risk. Any investor has to decide how much and what instruments should be included in any portfolio model.
An aggressive portfolio
An aggressive portfolio will primarily consist of stocks, possibly small-cap ones. The value of this portfolio may take wild swings throughout the year. This portfolio is oriented towards growth, and investors will try to fill it with various growth stocks that generate higher returns. You would not be worried about extensive corrections in those stocks as you are interested in the long-term growth of your portfolio.
As the crypto market belongs to the investment growth strategy, you can split the volatile part of your portfolio into stocks and cryptocurrencies. You may want to add fixed-income securities, such as government bonds, inflation resistance assets such as gold, and some high dividend stocks to generate extra fixed income for diversification purposes.
Here is what your aggressive portfolio might look like:
The three presented portfolios can have more variations and more flexible ways to allocate more assets within each type of portfolio. Whether conservative, medium risk or aggressive, they convey principles but are not an exact science out of themselves. Therefore, you can be more flexible than has been presented. Instead of compiling your conservative portfolio entirely with low-risk assets, you can add some 10% that are medium risk and possibly 3%-5% that are high risk.
The idea of safe is relative
You know that government bonds have been considered to be safe for decades. Yet, the idea might be changing, taking into account various geopolitical risks and tumbling returns from these instruments.
For example, around 15% of government and corporate-issued bonds carry negative yields. What does that mean? It means that when you buy these types of bonds, you will have to pay up for holding them, and at the end of maturity, you will get less money than your initial investment in the bonds.
It also means that the purpose of a conservative investment to help you preserve your capital is being defied, saying nothing of staying ahead of inflation, which is more than 5% globally in 2022, and probably remain such in the foreseeable future.
Thus, when talking about low-risk investments, you need to remember that assets considered safe can be such for a temporary period but become unsafe for some transitory period when the global economy is undergoing turbulence.
So, you need to do your due diligence and only then decide what assets you want to put into each portfolio as well as percentages of them.
Managing your portfolio by allocating assets according to appropriate risk categories enables you to meet your investment goals and reduce your risks while increasing your profits. The three main asset allocation strategies described in this piece should help you understand each strategy’s goals, risk tolerance, and time horizon.
After selecting the best allocation model for you, do not forget to go over your assets regularly to update the portfolio if necessary, reduce or increase your exposure to markets, and keep in line with your long-term investment goals.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.