Asset Allocation

Last updated:

June 25, 2023
3:54 am

Asset Allocation

Asset allocation is the process of dividing your investment portfolio amount different investment instruments like equities, bond, money market, cash and other instruments. The objective of asset allocation is to create a diversification that balances the risk and return base on investment objectives and the risk tolerance.

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1) Investment Goals

Getting to know what is your investment objective is the first step of asset allocation. Be it your investing objective is for retirement, children education, create emergency fund or general wealth accumulation. The investment objective will help to guide your asset allocation decision.

2) Time Horizon

Once you have defined your investment goals, the next step is to determine your investment time horizon for the goal. Whether it’s short-term, medium-term, or long-term. It will guide your asset allocation decision.

It should not be difficult to determine the investment duration if you know your investment objective clearly. For example if your investment objective is retirement planning and you set the retirement age then minus off your current age. You will be able to get the investment duration.

The longer investment horizon may allow you to allocate more into higher risk instrument like equities fund or balance fund that can potentially generate higher return. While the short term investment interval may require more stable asset class like Bond fund or Money Market fund.

3) Risk Tolerance

After identifying your time horizon, next is your risk tolerance. This is about how comfortable are you with the market volatility. It refers to your emotional and psychological ability to cope with market fluctuation. Consider your ability to stay calm during market downturns and your attitude toward the risks.

Use risk assessment tools to guide you in gauging your own risk tolerance. There are questions about your financial situation, investment knowledge, time horizon, and risk preferences. After answering those questions, a suggested risk tolerance profile result will be generated.

4) Asset Classes

Different asset classes has different return profile as well as different level of risks profile. The common assets classes include equities (stocks), bond (fixed income), money market (cash equivalents), real estate investment trust (REIT), and commodities. Understand each asset class with your investment time horizon as well as your risk tolerance will help you to allocate your portfolio well.

5) Target Asset Allocation

Based on your investment goals, time horizon, and risk tolerance; create a target asset allocation that spells out the specified percentage of your portfolio to be allocated to each asset class.

6) Diversification

The main objective of asset allocation is diversification. Different asset classes tend to perform very over time. Diversification will help to smooth out the market fluctuations. Diversification helps to reduce your investment risk.

7) Rebalance

As different asset classes perform differently over time. Your portfolio will change and be different from your original plan. Therefore you will need to restructure and rebalance your portfolio back in line with your original desired allocation. As time goes by, your investment objective may have changed. You may need to reset your targeted asset allocation.

Conclusion

Asset allocation is a dynamic process. The market situation changes and investment objectives change from time to time. It should be reviewed and rebalanced regularly based on your financial goals, and market conditions.

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