Asset allocation is the process of deciding how to divide your investment dollars across several asset categories. Stocks, bonds, and cash or cash alternatives are the most common components of an asset allocation strategy. However, others may be available and appropriate as well. The general goal is to minimize volatility while maximizing return
The process involves dividing your investment dimes among asset categories that do not all respond to the same market forces in the same way at the same time. Though there are no guarantees, ideally, if your investments in one category are performing poorly, you will have assets in another category that are performing well. Any gains in the latter may offset the losses in the former, minimizing the overall effect on your portfolio. Remember that all investing involves risk, including the possible loss of principal, and there can be no guarantee that any investing strategy will be successful.
Most asset allocation models fall somewhere between four objectives: preservation of capital, income, balanced, or growth.
Preservation of Capital
Asset allocation models designed for the preservation of capital are largely for those who expect to use their cash within the next twelve months and do not wish to risk losing even a small percentage of principal value for the possibility of capital gains. Investors that plan on paying for college, purchasing a house or acquiring a business are examples of those that would seek this type of allocation model. Cash and cash equivalents such as money markets, treasuries, and commercial paper often compose upwards of eighty percent of these portfolios. The biggest danger is that the return earned may not keep pace with inflation, eroding purchasing power in real term.
Portfolios that are designed to generate income for their owners often consist of investment-grade, fixed income obligations of large, profitable corporations, real estate (most often in the form of Real Estate Investment Trusts, or REITs), treasury notes, and, to a lesser extent, shares of blue-chip companies with long histories of continuous dividend payments. The typical income-oriented investor is one that is nearing retirement. Another example would be a young widow with small children receiving a lump-sum settlement from her husband’s life insurance policy and cannot risk losing the principal; although growth would be nice, the need for cash in hand for living expenses is of primary importance.
Halfway between the income and growth asset allocation models is a compromise known as the balanced portfolio. For most people, the balanced portfolio is the best option not for financial reasons, but for emotional. Portfolios based on this model attempt to strike a compromise between long-term growth and current income. The ideal result is a mix of assets that generate cash as well as appreciates over time with smaller fluctuations in quoted principal value than the all-growth portfolio. Balanced portfolios tend to divide assets between medium-term investment-grade fixed income obligations and shares of common stocks in leading corporations, many of which may pay cash dividends. Real estate holdings via REITs are often a component as well. For the most part, a balanced portfolio is always vested (meaning very little is held in cash or cash equivalents unless the portfolio manager is absolutely convinced there are no attractive opportunities demonstrating an acceptable level of risk.)
The growth asset allocation model is designed for those that are just beginning their careers and are interested in building long-term wealth. The assets are not required to generate current income because the owner is actively employed, living off his or her salary for required expenses. Unlike an income portfolio, the investor is likely to increase his or her position each year by depositing additional funds. In bull markets, growth portfolios tend to outperform their counterparts significantly; in bear markets, they are the hardest hit. For the most part, up to one hundred percent of a growth modeled portfolio can be invested in common stocks, a substantial portion of which may not pay dividends and are relatively young. Portfolio managers often like to include an international equity component to expose the investor to economies other than the United States.
Determining an appropriate asset allocation may be the most important single investment decision you make, because it will likely have more impact on your overall return than the selection of individual investments. Don’t hesitate to get expert help if you need it. And be sure to periodically review your portfolio to ensure that your chosen mix of investments continues to serve your investment needs as your circumstances change over time.
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(Article cr: www.thebalance.com)