Asset Allocation Methods for Investors

with No Comments
Portfolio allocation methods

Whether you are a beginner or an experienced investor, you should be aware of the various considerations that go into sound investment strategies. One of these considerations is asset allocation. Asset allocation is foundational when it comes to balancing the risk and rewards of an investment portfolio. Fundamentally, it is one of the most crucial components determining your overall returns, more than choosing your asset classes. Based on the investment principle that each asset class yields varying returns in different market conditions, investors must establish the appropriate mix of asset classes. This is where the asset allocation strategy comes into focus.

Understanding Asset Allocation

Asset allocation is defined as a strategy of investment where an investor allocated their investment portfolio across a range of asset categories. In this case, the asset categories include stocks, cash, bonds, and real estate. The primary objective is to minimise your investment risks while leveraging your expected returns.

Making the Asset Allocation Decision

Notably, every asset category comes with unique risks and returns. As a result, investors must take into account the various critical factors to achieve an optimal portfolio. These factors include time horizon, risk tolerance, investment goals, and investment options.

[1] Time Horizon

Time horizon refers to the duration you intend to invest to achieve a specified investment aim. This duration may be in the form of decades, years, or even month, weeks or days. As an investor, your time horizon determines your investment goals. The more extended the time horizon you have, the higher the chances of taking on a more volatile and riskier investment portfolio. This is because longer periods of investment present numerous economic cycles and market dynamics (ups and downs of the market), which may occur in favour of the investor.

The opposite is also true. An investor with a shorter time horizon is less likely to invest in a high-risk portfolio.

[2] Risk Tolerance

Risk tolerance is the financial value that an investor is prepared and willing to lose in exchange for a higher investment return. In this case, individuals with low-risk tolerance tend to make their investment decisions conservatively. They prefer low-risk investments in a bid to secure their assets. On the other hand, individuals with high-risk tolerance are willing to lose a significant amount of their investment to gain higher returns.

[3] Investment Goals

This refers to the financial or investment aspirations that you anticipate to achieve over a specified duration. Different goals, whether long term or short term, influence how people invest and take up risks. For example, a parent saving up for their baby’s college education invests differently from an individual hoping to quickly build up cash reserves to buy a property. Their time horizons and risk tolerance uniquely differ.

[4] Investment Options

The asset allocation process involves the creation of a portfolio with varying proportions of asset categories based on the investor’s risk profile. The asset categories available in the market are as follows;

Stocks – Of the key asset classes existing today, stocks are known for attracting the highest returns and risks. In addition to presenting great potential for growth, stock assets are very volatile. This explains why stocks are considered a high-risk investment in the short run. However, investors that have chosen stocks for more extended time horizons have earned stronger returns in the long run.

Bonds – Compared to stocks, bonds are generally less volatile. Returns from bonds are also relatively modest. In fact, some bond categories tend to yield returns as high as stock assets. However, the risk associated with high-return bonds can be quite high.

Cash – Cash investments are generally the safest of all asset categories. The risk of losing money on a cash investment is also extremely low. However, investment returns from cash and cash equivalents are lower compared to stocks and bonds. Cash equivalents include money market funds, savings deposits, money market deposit accounts, treasury bills, and certificates of deposit. The greatest concern for investors who choose cash and cash equivalents is the inflationary risk associated with cash assets. The fear is that this risk may exceed the return on one’s investment over time.

Speculative Assets – These can include assets such as cryptocurrencies, speciality ETFs (e.g. wine, art, collectible cars), options or other speculative financial instruments. Investors may include more speculative assets in their portfolio for the aim of achieving higher returns. Although these are regarded as some of the riskier types of investments, their adoption in investor portfolios has become more mainstream over the past few years. Thus, they should be considered by investors with a higher risk tolerance.

How Asset Allocation Works in Practice

Asset allocation operates on the principle that different asset categories yield varying returns. The strategy can help you guard your investment portfolio against declining value.

For example, Investor X has plans to invest or make savings for his retirement. Currently, Investor X has a total of $10,000, which he intends to invest for a time horizon of 5 years.

When applying the concept of asset allocation in such a scenario, Investor X can divide his portfolio among the various asset classes as follows;

  • Stocks – 50%
  • Bonds – 40%
  • Cash or Cash Equivalents – 10%

This means that Investor X will have $5,000 allocated to stocks, $4,000 to bonds, and $1,000 to cash or cash equivalents.

Methodologies for Asset Allocation

Generally, there is no fixed rule when it comes to asset allocation. Investors are different, and not every method of distributing portfolios over classes of assets may work well for you. So, how do you arrive at a methodology that best suits you and your nature of investment? Here is an overview of the various methodologies, with highlights of their management principles.

Age-Based Asset Allocation

This is a method of asset allocation where the decision to invest is based on your age. Age-based asset allocation operates on the principle that the mix of asset categories you hold for investment are likely to shift as you age. For instance, younger investors with longer time horizons are more likely to hold large amounts of stocks due to their high returns and growth potential. You have more time to ride out the market volatility of a given asset when you are young. But, as you grow older and as the retirement age approaches, investors tend to go for less risky options and cash equivalents to secure their original investments.

Traditionally, in the age-based asset allocation strategy, investors applied the old rule of thumb where one subtracts their age from 100 as the base value. This is to help them determine the value of the portfolio that should be held in stock assets. For instance, if you are 30, you will allocate 70% (100-30) of your portfolios to stocks. On the other hand, you would have to allocate 50% (100-50) of your portfolios to stock assets if you are 50 years old.

However, age-based asset allocation relies on an investor’s life expectancy when deciding on the exact proportion to allocate to stocks. An investor with a higher life expectancy may have to adopt a more aggressive asset allocation technique. This is why some investment experts recommend the use of 110 or 120 as the base value in determining the portfolios to be allocated to stocks.

Target-Date Funds Allocation

Target-date funds allocation, also known as life-cycle funds allocation, is a strategy where investors hold a mix of stock categories in a fund based on a specified target date. As the target date of the fund approach, the mix of assets held in the fund becomes more conservative.

For instance, if you are 30 and intend to retire at 55, then you can hold your mix of assets in a fund with a 25-year target date. As the retirement age approaches, the proportions of assets held in the fund increase spontaneously. This asset allocation strategy is considered complex, following the endless standardisation issues associated with it. The ratios applied in dividing the fund into a mix of assets may vary with an individual’s investment goals, time horizon, and risk tolerance.

Assuming an Investor A has an initial investment mix of 50/50, comprising of stocks and bonds. Five years down the retirement road, the proportion of stocks held in the fund increases by about 15%. As a result, Investor A will have to lay off 15% of his bonds to increase his stock proportion. This creates a new mix of investment, with a stock to bond ratio of 65:35. The ratio may continue to change until the target date is achieved.

Strategic Asset Allocation (SAA)

This is an investment technique involving the identification and rebalancing of asset allocations for long-term results. Strategic asset allocation operates around a base policy mix, which is a proportionate combination of the various asset categories based on the projected returns on investment (ROIs). Such factors as time horizon, risk tolerance, and investment goals must be taken into account when you use the SAA methodology.

Through this method, strategic asset allocation weights are established for all the asset categories. If the allocation weights of a given asset category deviate from the strategic asset allocation weights, rebalancing is sought. SAA is similar to the buy-and-hold tactic, where the asset weights are identified and applied for a relatively long duration.

For example, if an investor earns 10% returns on stocks and 5% on bonds every year in their history of investment, then a 50/50 mix of stocks and bonds should provide an annual return of 7.5%.

Tactical Asset Allocation

The strategic asset allocation method comes with various challenges relating to investment policies in the long run. As a result, investors may opt to trigger tactical deviations from the mix of assets to maximise on investment opportunities in the short run. The engagement of tactical deviations in the short term is known as tactical asset allocation. This methodology makes it possible for investors to capitalise on their investments while coping with the dynamics of the market.

Ideally, tactical asset allocation provides flexibility in your ability to participate in market conditions that favour one asset category more than the others. However, this strategy demands a lot of discipline to identify the exceptional or unusual, short-term investment opportunities as they arise. This way, you can rebalance your portfolio to position your assets for long-term returns.

Constant-Weight Asset Allocation

This method applies the buy-and-hold strategy in creating and rebalancing an investor’s portfolio to achieve the expected asset mix. What this means is that investors will buy and hold more of a stock when there is a decline in its value. When the stock prices rise, the investor will then sell a significant proportion of their portfolio.

The advantage of using the constant-weight asset allocation method is that you can always and continuously rebalance your portfolio. If the value of one asset declines, you would buy more of it. And if the value of that same asset grows, you will sell it off. As the old rule of thumb goes, the proportions of a given asset class should never deviate more than 5% from its initial value.

Insured Asset Allocation

This is the ideal asset allocation strategy for risk-averse investors. The method involves developing a base portfolio or threshold below which your portfolio must never fall. As long as the value of your portfolio is above the established threshold, it is easy to decide on the assets to buy, sell, or even hold to leverage your investment. In case your portfolio drops below its base value, investment experts recommend going for risk-free assets.

Dynamic Asset Allocation

This is probably the most popular strategy of asset allocation. Like constant-weight asset allocation, this method allows investors to continually adjust the mix of assets in their portfolio depending on the existing economic and market conditions. However, dynamic asset allocation moves to the opposite of the constant-weight strategy. As part of this strategy, you purchase assets that increase in value and sell those that decline in value. Most investors consider dynamic asset allocation as an ideal way to minimise losses and maximise gains depending on the lows and highs of the market. For example, if the market is strong and favourable, you purchase assets with an expectation to make further gains. On the other hand, in a weaker market, you will sell your assets as you anticipate a further decline in market value.

Wrap up

Asset allocation plays a very crucial role when generating and balancing your investment portfolio. Fortunately, there are plenty of methods and strategies that you can apply to distribute your portfolio over various asset categories. These include the age-based strategy, target-date, dynamic, insured, constant-weight, and strategic asset allocation methodologies. However, deciding on an asset allocation method must take into account such factors as your time horizon, investment goals, and risk tolerance.