Asset allocation: Factors
In this section, we will discover diversification and we will tie it all together to get a full picture of the importance of portfolio management.
Importance of Asset Allocation
Remember, asset allocation is the distribution of your investment capital among different assets or asset classes, such as stocks or bonds (cash is also considered a class). An optimal asset allocation can lower investment risks and increase returns simultaneously. It is demonstrated that 90% of your returns will depend on your asset allocation., which makes it more important that individual asset picking.
Let’s imagine that Laura chose to invest 30% of her capital in stocks and 70% in bonds. That would yield a 50% total return after ten years. That return wouldn’t change much regardless of the particular assets she picked, it’d fluctuate between 45% and 55%. Because, as we explained before, in the long-run, some 90% of your returns are typically derived from your asset allocation, and not from your individual asset picks.
Factors that shape your optimal asset allocation
As an investor (or a future investor) you have certain personal characteristics that differentiate you from other investors, and they change over time. For instance, as investors grow older, they are more likely to prefer more stable portfolios, since they can afford fewer and fewer risks. The process of determining the optimal asset mix is very personal and important for any investor. Your optimal asset mix is the asset allocation that is best for you at every point in your life. Here are the factors that you should take into account when deciding what asset allocation is best for you:
Time horizon is the period of time (months, years or decades) that you expect to be investing to achieve your financial goals.
- Longer time horizon: investors that are in it for the long-run may have more room for risk in their portfolios. They may want to invest in riskier, more volatile, assets that are likely to yield higher returns because they simply have the time to ride out most economic crises and downturn market movements. That is why it is recommended for young adults to invest a good part of their retirement funds in risky assets, like stocks.
- Shorter time horizon: investors that are trying to save up for specific moments of their lives (like to buy a house, etc.), which typically have shorter time horizons, may not be able to afford that much risk, so they tend to invest in safer assets, like bonds. The older you get, the higher your allocation in bonds should be.
Risk tolerance is your ability and/or willingness to take on risks. Each individual has a different level of risk tolerance, for instance, a skydiver is likely to have a higher risk tolerance than a chess player. In the case of finance, risk refers to the possibility of losing some or all your money invested, which you inherently trade for higher returns.
- High-risk tolerance: these people are also known as aggressive investors, and they are more likely to take on extra risks in order to achieve the highest returns possible.
- Low-risk tolerance: these people are also known as conservative investors, and they tend to avoid extra risks and choose the investments that will generate lower returns in order to preserve wealth.
Expertise & guidance
The more you learn and understand the finance world, and in the world in general, the more likely you are to make educated investment decisions and to take controlled risks in order to achieve better results. This is also a valid point if your portfolio is being guided (or managed) by an experienced entity or individual.
It the frequency in which investors trades (buys or sells) their assets. The level of activity of investors in their portfolios should be positively correlated to their level of expertise.
- Active: these investors are hands-on, they buy and sell assets very often for short periods of time in order to try to beat the market or a benchmark (like the S&P 500). They are more likely to take on higher risks and are typically more knowledgeable. However, it is a complicated and costly strategy, because trading fees can add up quickly.
- Passive: these investors tend to buy and hold their assets for the long-run, making little changes along the way to keep their portfolios balanced. This strategy is for the more patient, resistant investors. However, it is a relatively “cost-effective” strategy, because they will barely have any trading fees.
Your financial goals can definitely shape your personality as an investor, which will affect your allocation. For instance, if you are investing to pay for your children’s college tuition fees, you are less likely to invest in risky assets than young adults that are investing to buy a house ten years from now or to grow their retirement funds.
Diversifying is one of the most important factors of asset allocation. It is essentially spreading your capital to minimize risks; in other words, investing in different types of assets in order to reduce your investment risk.
You may have heard the saying “don’t put all your eggs in the same basket”. It is a piece of advice to diversify, to allocate your capital (“your eggs”) into different asset classes or endeavors (“baskets”), which increases the chances that if one investment is losing value, another may be gaining.
An optimal mix of assets may help your portfolio to benefit during market prosperity while suffering less during downturns. The level of diversification that you choose will determine your portfolio’s risk measure and its returns. For instance, if an investor allocated 100% of his capital to a stock and it bankrupted within a year, he’d have lost all his money. However, if he decided to spread his capital across 10 assets and one of them went bankrupt, he would have only lost 10% of his money.
In the next section, we will get into cash. Then, we will discover all the other asset classes and their effect on diversification.