Asset allocation is the process of diversifying your investments across several asset classes, such as stocks, bonds and cash. Most investment experts agree that asset allocation, rather than picking the single "right" investment or trying to "time" the market, is the primary determinant of your investment returns.

Diversification across asset classes and employing a strategic asset allocation can result in consistent portfolio performance and help manage your investment risk at a level consistent with your risk tolerance. Investors cannot avoid risk altogether, but rather take action to manage risk. Establishing a disciplined investment policy which incorporates a strategic asset allocation can help you avoid the temptation of investing in the current 'hot' stock or asset class. Since various asset classes are subject to different market forces diversification may reduce risk and manage volatility. Creating an investment policy and strategic asset allocation requires a clear understanding of your risk tolerance and identification of your goals and objectives which will determine your time horizon and liquidity needs.

Asset allocation seeks to enhance the performance of your investment portfolio using diversification and disciplined investing. However, using an asset allocation methodology does not guarantee greater or more consistent returns.

Investment risk is the uncertainty of achieving a desired investment return. Some investments will be fairly stable in their performance, growing slowly from year to year. Other investments may exhibit ranges of volatility, climbing steeply in value one year and dropping sharply the next.

Investors need to determine their comfort level with volatility - the possibility that their investment principal may not grow as sharply or perhaps decline in value. While this is a subjective element in an investor's profile, financial advisors have effective tools to measure and categorize your risk tolerance. While investors typically equate risk with sustaining losses related to an aggressive investment strategy, investing too conservatively can expose you to inflation risk - the potential that your returns will not keep up with inflation, thus eroding your principal. Consideration of your future liquidity needs, views about the stock market, and perspectives on the economy all factor in to determining your personal risk profile.

You also need to determine how long a period of time you have before you need to access your accumulated assets. If you're 30 years old and investing for retirement, you have a relatively long investment horizon. Your risk profile and willingness to put a larger share of your funds into aggressive investment vehicles will differ from that of a 55-year-old planning to retire in five or 10 years.

A long time horizon, say 20 to 30 years, means you can afford to take on additional risk. Accepting greater risk over time also means you can expect to realize higher returns in the long run and you will have more time to recover from any losses. Conversely, a shorter time horizon - if retirement is near or if you're investing for a child's college education five years down the road - may dictate that you mitigate risk with a conservative portfolio and, most likely, a lower but more stable overall rate of return.

You should also consider the length of time you will need to withdraw money from your accumulated assets. You may not retire until you're 62 or 65, but depending on your life expectancy, you may need to live off your retirement funds for 20 or 30 years or more. Planning for these future withdrawals needs to be part of your investment time horizon.

In general, the longer you have to invest, the more time you have to weather periodic swings in the investment markets. As you approach your goal, however, your portfolio has less time to recover from market dips, so you may want to gradually shift to a more conservative asset allocation strategy.

After determining your investment goals, risk tolerance, time horizon and financial situation, you should work with your financial advisor to establish the asset allocation. As time goes on, you will need to conduct portfolio review, no more than quarterly and no less than annually, to review performance and ensure that your portfolio continues to reflect your target asset allocation. Furthermore, if your investment objectives change, a regular portfolio review will allow you to rebalance it to align with your objectives and time horizon. Rebalancing your portfolio may be triggered by a significant life event which changes your investment situation or future outlook.

back to Home