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.
Asset allocation 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 potentially 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, or tax risk. An individualized asset allocation strategy seeks to mitigate the risks of any one asset class though diversification and balance. An investor’s allocation of assets should 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. Each individual’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 pursuing his objectives.
Taxation
Investing in a mix of asset classes will have varying tax consequences.
A personalized asset allocation strategy evolves and includes periodic reviews. 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. As people move through life’s stages their needs, preferences, priorities and risk tolerance change and so too must their asset allocation strategy. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation do not ensure a profit or protect against a loss.
