A person can invest their wealth in an attempt to grow it. Investors should consider the risks as they attempt to increase their wealth.
Finance experts recommend a combination of asset allocation and diversification to help address risk.
Is There A Difference Between The Two Strategies?
It is common to hear the words diversification and asset allocation together. Some people even use them interchangeably.
Although the terms are similar, they are not the same, and it is important to differentiate them.
Asset Allocation
Asset allocation describes how an investment portfolio is structured into different asset classes, such as stocks, bonds, and cash. The percentage for each category is dependent on the investor.
Stocks typically present the highest risk on the market, followed by bonds and cash. The strategy spreads out investment among the assets to minimize losses as much as possible.
An example of this is, an investor who divides their financial portfolio this way: 50% stocks, 35% bonds, and 15% cash.
These three categories have different determining factors, and it is unlikely that all fail at once. This can allow the investor to counter losses from one asset with gains from another.
Proper asset allocation can lay a strong foundation for financial portfolios.
Stocks
Corporations sell interest in their companies in the form of stocks to raise funds. Those who purchase them have a share in the organization.
An investor buys a stock, in hopes that its value will rise so they may sell it and make a profit. The share value can also fall depending on the market and other associated risks. This can cause volatility for amongst equity assets.
As an asset category, stocks typically have the highest growth potential.
Bonds
Bonds describe an indebtment between the lender and borrower that are issued by companies and government authorities.
Organizations can trade these debts among themselves. They have maturity dates, at which point creditors are to be paid in full.
These types of investments are often carrying less risk and can offer modest returns.
It is common for investors to increase their bond allocation relative to stocks as they approach their financial goals to reduce short-term volatility.
With no need for extra growth, the trade-off for security can be more attractive to an individual.
Cash
Some of the safest investments can be cash or equivalents such as treasury bills, money market funds, and savings. They tend to have the lowest volatility but also have the lowest real returns among asset classes.
Inflation is typically the leading concern for those who invest in cash. As the cost of goods and services in an economy increases, it decreases the purchasing power of their currency.
Depending on where a person lives, inflation can outpace and devalue currencies over time.
Diversification
In any asset allocation structure, investment in a category is often spread over various market sectors. This can limit the investor's exposure.
Using the example in the section above, the investor assumes a higher risk if they have over-concentrated positions. If they allocate 50% of their portfolio into stocks and invest the 50% into shares of one company, they would be exposed to more risk compared to diversifying it amongst several companies.
A common diversification strategy includes spreading investments across different asset classes to help address risk.
How to Determine the Asset Allocation that’s Right for You
Effective asset allocation mostly depends on time horizon, risk tolerance, and goals. These factors can influence how an individual invests their portfolio.
Time Horizon
Time Horizon measures the expected time for reaching a particular investment goal. It determines the moment in the future when the individual will need to access the funds committed.
At age 40, the time horizon for a retirement investment could be 25 years or more, based on the person's goals. The same individual investing in their kid's college fund can have a ranging time horizon depending on the age of the child and their education plans. Age can shorten the time horizon of any investor and can also be considered a determining factor.
A longer time horizon can make a person more comfortable with taking risks and managing volatility. They have the option of investing in assets with greater volatility as they have a longer time frame until the funds are needed.
Risk Tolerance
"Nothing ventured, nothing gained" is a phrase that can typically be used to define the concept of risk tolerance.
It considers one's willingness to risk losing a part or all of their initial investment in exchange for potential returns. The magnitude of the reward depends on the level of risk. A person comfortable with taking such chances in the hope of greater rewards has a high-risk tolerance.
Risk tolerance is psychological.
Asset Allocation Models
These represent the possible strategies an investor can use to guide their asset allocation. There is a range of approaches, from conservative to aggressive.
Aggressive Models
Aggressive asset allocation models prioritize returns. Therefore, aggressive models will typically hold more stocks in comparison to other asset classes in hopes of greater returns. An investor in a more aggressive model can expect more volatility within the portfolio.
They are popular with investors that have a high-risk tolerance level.
Conservative Models
A conservative approach involves having a greater allocation in asset classes such as cash and bonds. It is appropriate for people that have a low-risk tolerance.
The goal is to preserve the principal investment instead of focusing on returns. This can be considered a capital preservation strategy.
Get Advice
Knowledge of asset allocation models is not sufficient to guide investment strategies. Speaking with a financial advisor can be helpful in making such decisions.
This material was prepared for The Kelley Financial Group’s use.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation do not ensure a profit or protect against a loss.
Stock investing includes risks, including fluctuating prices and loss of principal.​ Bonds are subject to market and interest rate risks if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability.
This material was prepared for The Kelley Financial Group’s use.