Asset allocation is the process of dividing your investments among different asset classes, such as stocks, bonds, real estate, and commodities, in order to achieve your financial goals. It is a key aspect of investment strategy that helps to reduce risk and maximize returns by spreading your investments across different types of assets.
Here are the steps to perform asset allocation and examples to help illustrate each step:
Determine your investment goals
Before you start allocating your assets, you need to determine your investment goals. This includes deciding how much money you want to invest, what you want to achieve with your investments, and how much risk you’re willing to take on. For example, if you’re saving for retirement and want to maximize your returns while minimizing risk, you might choose a more conservative asset allocation strategy.
Assess your risk tolerance
Your risk tolerance refers to your willingness to accept risk in pursuit of higher returns. You can assess your risk tolerance by considering factors such as your age, investment time horizon, income, and financial goals. For example, a young person with a long investment time horizon may be willing to accept more risk than an older person who is closer to retirement.
Evaluate your current portfolio
Next, you need to evaluate your current portfolio to determine which assets you already have and which assets you need to add to achieve your investment goals. This can be done by reviewing your investment statements or working with a financial advisor.
Allocate your assets
Once you have determined your investment goals and assessed your risk tolerance, you can start allocating your assets. A common asset allocation strategy is to divide your investments into a mix of stocks, bonds, and cash. For example, a conservative portfolio might allocate 60% to bonds, 30% to stocks, and 10% to cash.
Rebalance your portfolio
Over time, your asset allocation may become unbalanced due to changes in the value of your investments. To maintain your desired asset allocation, you’ll need to regularly review and rebalance your portfolio. For example, if your stocks have performed well and now make up 40% of your portfolio, you may need to sell some of your stocks and buy more bonds to restore your desired 60/30/10 allocation.
Let’s say a person named John is 35 years old and has a long investment time horizon. He has a moderate risk tolerance and wants to achieve a well-diversified portfolio. He currently has $100,000 invested in a mix of stocks and bonds and wants to allocate his assets as follows: 60% to stocks, 30% to bonds, and 10% to cash.
John would first evaluate his current portfolio to determine how much of each asset class he already owns. Let’s say he has $60,000 invested in stocks and $40,000 invested in bonds. To achieve his desired allocation, he would need to sell some of his stock investments and purchase more bond investments until he has 60% of his portfolio invested in stocks, 30% in bonds, and 10% in cash.
In conclusion, asset allocation is a key aspect of investment strategy that helps to reduce risk and maximize returns. By determining your investment goals, assessing your risk tolerance, evaluating your current portfolio, and regularly rebalancing your portfolio, you can achieve your financial goals and potentially achieve a well-diversified portfolio.