Asset Allocation 101
Martin Landry, CFA, CFP®, CAIA, CIMA®, CIPM, AIF®Manager IMRG, Senior Portfolio Manager
Jan 17, 2017
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks from U.S. and foreign companies, bonds from governments and corporations, and cash or money-market funds.
Determining which mix of assets to hold in your investment portfolio is a very personal process and depends on how long you plan to invest, what you are trying to achieve with saving your money and investing it, and even how patient or anxious you are when the value of your total investments rises and falls with the course of the markets and time. Thus, the asset allocation that works best for you at any given point in your life will generally be determined by your time horizon and your risk tolerance.
Your time horizon is the expected number of months, years or decades during which you will invest to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier or more volatile collection of investments because he or she can wait out slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor saving for a down payment on a house would likely take on less risk because he or she has a shorter time horizon.
Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor (one with a high risk tolerance) is more likely to risk losing money in order to obtain better results. A conservative investor (one with a low risk tolerance) tends to favor investments that will preserve his or her original investment.
When it comes to investing, risk and reward are generally entwined. You’ve probably heard the phrase “no pain, no gain” — words that come close to summing up the relationship between risk and reward. All investments involve some degree of risk, and if you intend to purchases securities — such as individual stocks or bonds or even mutual funds, which are pooled collections of securities — it’s important that before you invest you understand that you could lose some or all of your money.
During most cycles of the markets, the reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you generally have a greater likelihood of making more money by carefully investing in asset categories with greater risk (e.g., foreign stocks or high-yield bonds), rather than restricting your investments to assets with less risk (e.g., government Treasury bills).
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money, and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another.
The practice of spreading money among different investments to reduce risk is known as diversification, which is analogous to the age-old adage “Don’t put all of your eggs in one basket.” At its core, diversification allows investors to reduce business-specific risk, meaning the fortunes of any single company will not have a significant impact on an investor’s fortune. Naïve investors often practice diversification by selecting more than one financial advisor, and naïve financial advisors often practice diversification through product proliferation.
By selecting the appropriate group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. There should also be a balance regarding the amount of risk within your portfolio. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stocks or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family’s summer vacation.
Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments — that it’s even more important than the individual investments you purchase. Contact your financial advisor to help you determine your initial asset allocation and suggest adjustments for the future.
Neither asset allocation nor diversification protects against a loss in declining markets.