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 different asset classes have varying cycles of performance, and that by investing in multiple classes, the overall investment returns will be more stable.
All investments involve some sort of risk, whether it’s market risk, interest risk, inflation risk, liquidity risk, or tax risk. An individualized asset allocation strategy seeks to mitigate the risks of any one asset class though diversification and balance.
Individual Strategy
Asset allocation is an individualized strategy; everyone is unique to their goals and objectives. Each strategy is built on the careful consideration of key elements of an individual’s financial profile:
Investment Objectives: What the investor hopes to achieve using their investment dollars: improve current lifestyle, achieve capital growth, or fund a specific goal, such as a college education.
Risk Tolerance: This reflects each investor’s comfort level with possible losses incurred by market fluctuations. Inflation risk and interest risk need to be considered as well.
Investment Preferences: An investor may prefer one asset class over another based on belief systems or interest in the characteristics of that class.
Time Horizon: The length of time an investor is willing to commit to achieving their 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 make adjustments to your allocation. That’s why a sound asset allocation strategy includes periodic reviews. 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 is driven by complex mathematical models and should not be confused with the much simpler concept of diversification.