Asset AllocationExplained & Defined
What is Asset Allocation?
Asset Allocation is a type of strategy that investors take in order to minimize the risks associated with investments and maximize their returns by allocating different assets categories.
The asset allocation categories are: equities, fixed-income, and cash and cash equivalents according to the risk appetite, time horizon, and goals of the investor.
Assets that belong outside of these categories are referred to as Alternative Assets.
Over time, these asset categories will behave differently and will have different levels of risk and return.
Why Asset Allocation is Important
Due to the different factors that affect asset allocation, asset allocation will be different for every individual.
This may be the case, it is of general consensus that the primary consideration that investors take when making investments is how their assets are allocated and not what type of investments they undertake.
Asset allocation determines the result of how well an investment turns out.
When an investor has short-term goals (car purchase or college tuition), the majority of the investment would be towards short-term bonds or certificates of deposit.
However, if an individual has a long-term goal, the majority of the asset allocation can be done towards the retirement fund or in stocks.
Where a person allocates the majority of their assets will depend greatly on his or her risk appetite.
An investor who is risk-averse would avoid investing in the stock market and put their money elsewhere – lesser risk, longer-term, although lesser returns.
Asset Allocation Strategies
Because there is no formula for asset allocation that works for all, there are different asset allocation strategies used depending on the goal, risk appetite, or time horizon.
Age-Based Asset Allocation
This type of strategy is dependent on the age of the investor.
Financial advisors suggest that investors deduct their age from a base number of 100.
If an investor is only 35 years old, age-based asset allocation suggests that 65% of the investments should be allocated towards riskier investments such as stocks.
This type of strategy also suggests that if the investor is older, the more conservative the investments should be.
Life-Cycle Funds Asset Allocation
Other terms used for life-cycle funds asset allocation are life-cycle or target-date funds aimed to maximize the Return on Investments (ROI) considering the age, risk tolerance, and investment objectives of the investor.
Critics of this asset allocation strategy argue that creating a standardized approach to asset allocation can raise problems because every investor is unique and each will require a different solution.
Bottom Line
Minimizing the risk of investments requires an investor to have a diversified portfolio across the three main asset categories – cash and cash equivalents, equities, and fixed-income.
The allocation of these assets will depend on a number of factors but mainly, it will be affected by the investment objectives, age, and risk tolerance of the investor, meaning that the majority of the allocation percentage will be put toward certain asset classes.
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University of Pennsylvania "Why Asset-Allocation Decisions Are Complex — and What to Do About It" Page 1 . April 6, 2022
The University of Iowa "Asset Allocation" Page 1 . April 6, 2022