Asset Allocation Basics
Asset allocation has become an established investment strategy for those who understand the long term nature of investing and the need to achieve an optimum level of portfolio balance and diversification in order to mitigate risk and achieve more stable returns. The core strategy involves selecting a mix of asset classes based on an investor’s financial profile, investment objectives, preferences, time horizon and risk tolerance.
The key behind the strategy is the mix of asset classes that, depending on how much or how little they correlate with one another, will create a basket of counter weights that will keep the overall value of the portfolio from tipping too far in one direction. For instance, the correlation between stocks and bonds is relatively low, so that, when stocks perform poorly, bond are likely to perform better. A well balanced and diversified portfolio will consist of several different asset classes - stocks, bonds, alternative investments, cash equivalents, etc. - all with varying levels of correlation with one another.
All investments are susceptible to some form of risk: market risk, interest rate risk, inflation risk, liquidity risk and the risk of taxation. A well planned asset allocation strategy is as much about allocating risk as it is allocating assets, and when done effectively, the overall risk of the portfolio is mitigated by off-setting the market performances of the various asset classes. Although asset allocation does not guarantee your account will be protected against losses in a declining market, a properly allocated portfolio should even welcome economic change and uncertainty as there is more likely to be portions of the portfolio that do respond favorably.
Portfolios require frequent tune-ups, also known as rebalancing. Certain parts of the portfolio will perform as expected while others will under-perform or out-perform expectations. As a result, the portfolio can become unbalanced relative to the assumptions and objectives on which the allocation was based. The one certainty about the economy is that it will change as will the risk factors. Most important is that the allocation of assets and risk in your portfolio continue to reflect your needs, preferences, priorities and your outlook.
