Asset allocation is the process of selecting a mix of asset classes that closely matches an investor’s financial profile in terms of their investment preferences and tolerance for risk. It is based on the premise that the different asset classes have varying cycles of performance, and that by investing in multiple classes, the overall investment returns will be more stable and less susceptible to adverse movements in any one class.
All investments involve some sort of risk, whether it’s market risk, interest risk, inflation risk liquidity risk, tax risk. An individualized asset allocation strategy seeks to mitigate the risks of any one asset class though diversification and balance.
When done properly, an investor’s allocation of assets will reflect his desired goals, priorities, investment preferences and his tolerance for risk. Asset allocation is an individualized strategy, so there really is no perfect mix of assets. Everyone’s strategy is built on the careful consideration of the key elements of their financial profile:
Investment objectives: What it is the investor hopes to achieve using his investment dollars – improve current lifestyle, achieve capital growth, fund a specific goal, such as a college education.
Risk tolerance: This reflects the investor’s comfort level with market fluctuations that can result in losses. Inflation risk and interest risk need to be considered as well.
Investment preferences: An investor may prefer one asset class over another based on a certain bias or interest towards the characteristics of that class.
Time horizon: The length of time an investor is willing to commit to achieving his objectives.
Taxation: Investing in a mix of asset classes will have varying tax consequences.
An evolving strategy
About the only certainty when it comes to the financial markets is that they will change, and so will your financial situation. Through market gains and losses, a portfolio can become unbalanced and it may be important to adjust your allocation. As people move through life’s stages their needs, preferences, priorities and risk tolerance change and so too must their asset allocation strategy.
Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification.