Asset Allocation

After your plan is delivered and you have a game plan for your wealth, you may want to know more about the tactical side of executing your plan. One large part of this is asset allocation. Asset allocation involves diversifying an investment portfolio into different asset categories such as stocks, bonds, and cash and then monitoring its performance over time. Asset allocation is personal and should be different for every individual, as everyone has different goals, time horizons and tolerance to risk.

Your Time Horizon is the expected number of months, years or even decades in which you plan to invest to achieve a particular goal. A longer time horizon typically indicates a greater ability to withstand volatility than those with shorter time horizons as they may need the money sooner and cannot handle a market fluctuation. For example, someone with a long time horizon may be looking greater than five years into the future and might be saving for retirement, investing for future generations or putting away money for a child’s college. A shorter time horizon may be less than five years for activities like buying a home, going on a vacation or purchasing a new business.

Your Risk Tolerance is your ability and willingness to lose some or all your investment in exchange for a potentially greater return. A higher risk tolerance typically correlates to a more aggressive portfolio allocation and vice versa. Risk directly impacts the return you’re trying to achieve. All investments involve a degree of risk – if you are worried about losing your funds then you would likely want to reduce the risk of your portfolio instead to preserve capital.

Stocks are deemed to have the highest inherent risk of the asset categories covered here. Stocks, also referred to as equities, are shares of publicly traded companies like Tesla, Apple, or Walmart. They strive to achieve a higher rate of return but also face more fluctuation in value than bonds or cash. If an investor can withstand volatility over a longer period of time (think greater than five years), the likelihood increases that they could potentially reap the greatest rewards from returns on equity investments.

Bonds are generally far less volatile than stocks but offer more modest returns. Bonds are essentially IOUs from either the government or a company that state the amount the bondholder will be paid back on a certain date in the future, called the maturity date. As an investor nears in on a financial goal such as retirement or buying a house, they might increase their position in bonds to reduce risk. There are high-yield or “junk” bonds, which carry higher risk with a potential of earning returns close to those of the stock. Your advisor will look at factors like your time horizon and risk tolerance to determine which are appropriate for you.

Cash is the ‘safest’ investment but also offers the lowest (and sometimes even negative) returns due to inflation. The probability of losing money is this asset class is extremely low, which makes cash great for short term goals (less than a year into the future). Cash does come with inflation risk (also called purchasing power risk) because it essentially loses value each year as more is printed – making the “return” negative over long periods of time.

Diversification is the act of investing among different vehicles or sectors to reduce risk. Various types of investments will react differently to changing economic conditions, which makes diversification essential to capture the upside returns of market movement.

Rebalancing is the process of realigning the weightings of a portfolio of assets. Your advisor’s job is to determine what percentage of your overall portfolio should be invested in various instruments or sectors of the market that are aligned with your goals to achieve an expected return. As the market moves and certain sectors do better than others, the weightings are skewed from their original targets. A rebalance involves selling a portion of the investments that did well and purchasing into those that are cheap to buy to return the portfolio to its original allocation. As this is done over time, the return will be closer to what is expected, rather than investing once and not making readjustments.

Asset allocation is just one tactic used by your advisor to help you reach your goals. Great wealth plans do not rely only on returns produced from asset allocation, but rather use it as one tool that works with other strategies to move you in the right direction.