Investors today face bewildering choices about how to invest their money. As market conditions change and new financial products appear and disappear, making sense of information about effective ways to manage wealth could be difficult.
Making decisions about investments and portfolios is not an easy task. Individuals are bombarded with a dizzying array of investment options. Information abounds, advice comes from all quarters, recommendations often contradict, and new products and asset classes are invented quickly.
Main Concerns in Asset Allocation
- How should investors make sense of the information that exists about wealth management?
- How should they create a portfolio of investments that will provide sufficient money to see them through life and help them achieve their financial goals?
While these questions may seem daunting, they are essential questions that should be asked. One of life’s most crucial requirements is to save and invest money for the future.
Allocation of Investor’s Assets
Asset allocation is simply investing an investor’s assets across broad categories of investments. The percentage of the investor’s portfolio allocated to stocks, bonds, mutual funds, or cash depends upon an individual’s financial goals, investment time frame, and tolerance for market risk.
Generally, a large portion of the investor’s portfolio should be allocated to the following:
- Cash Equivalents
A large portion of an investor’s portfolio should comprise stocks; if an investor:
- Wants the potential to make substantial returns on the investments to reach the financial goals.
- Has a relatively long investment time frame, i.e., 5 to 10 years or longer
- Has the risk tolerance to withstand market volatility?
A large portion of the investor’s portfolio should have bonds; if an investor has:
- The main goal is to preserve the initial investment
- A mid-term to long-term investment timeframe
- The patience to withstand some fluctuation in asset values on the way to achieving the goals
- A need for an income stream from the investment
A large portion of the investor’s portfolio should be put to cash equivalents:-
- If an investor is comfortable with a minimal return on the investible amount.
- If an investor needs to access a significant portion of the amount soon.
Determination of Asset Allocation Model
Determining an appropriate asset allocation model for a financial goal is complicated. An investor tries to pick a mix of assets with the highest probability of meeting the financial goals at a level of risk a person can bear.
Once the importance of time horizon and risk tolerance is understood along with some investing experience, an investor would feel comfortable creating an asset allocation model.
Financial experts believe that determining an asset allocation is an individual’s most crucial decision concerning investments.
What is an Asset Allocation Strategy?
An investor would always prefer an investment that offers the highest return for any given amount of risk. To the extent that investors differ in their preference for risk, they would mix different amounts of zero-risk ‘cash’ with their chosen combination of risky assets like shares, fixed income securities, real estate, etc.
In the same way, an investor may use one of the commonly used asset allocation strategies to build an investment portfolio according to the objectives of the investment plan.
Types of Asset Allocation Strategies
There are several types of asset allocation strategies, such as:
- Strategic Asset Allocation
- Tactical Asset Allocation
- Dynamic Asset Allocation Strategy
Strategic Asset Allocation
Strategic asset allocation could be characterized as a long-term asset allocation. The objective is to determine whether the long-term regular asset mix represents the desirable balance of risk and return. In developing the strategic asset allocation, several issues should be addressed, such as:
- Should the investors use the optimization technique to determine the optimal asset mix, or should the combination be represented by an existing benchmark, e.g., Nifty or Sensex?
- How should strategic asset allocation be altered in the light of changing economic environment?
Tactical Asset Allocation
Over the long run, a strategic asset allocation strategy might seem relatively rigid. Therefore, an investor may find it necessary to occasionally engage in short-term tactical deviations from the mix to capitalize on unique investment opportunities. This flexibility adds a component of market timing to an investment portfolio, allowing an investor to participate in economic conditions that are more favorable for one asset class than for others.
Tactical asset allocation could be described as a moderately active strategy since the overall strategic asset mix is returned when desired short-term profits are achieved. However, this strategy demands discipline, as an investor must first recognize when short-term opportunities are available and then rebalance the portfolio to the long-term asset position.
Dynamic Asset Allocation Strategy
Dynamic trading strategies for asset allocation are designed to change the distribution pattern of the portfolio. The best known of these strategies is the Portfolio Insurance Strategy, which is intended to set the floor for the portfolio’s value. An investor can create a new asset class through dynamic trading strategies; for example, few hedge funds employ active trading strategies to create a new asset class that outperforms simple buy-and-hold strategies when there is increased market volatility. Any asset allocation strategy that systematically changes through time could be classified as a dynamic trading strategy. For instance, the constant mix strategy could be considered a type of active trading strategy as it would change the distribution of return when compared to the buy and hold strategy.
Conclusion: Asset Allocation for Wealth Creation
Asset Allocation is a disciplined approach with the primary goal of protecting assets while investing to gain in the long term. However, there is no assurance that these asset allocation strategies will achieve the intended return targets. Nevertheless, following an asset allocation strategy as per risk profile and prevailing financial and economic situation may help to achieve your financial goals like: –
- Achieving financial security,
- Enhancing retirement funds,
- Creating an estate to transfer wealth to the next generation, etc.
An asset allocation strategy should be part of your investment plan.