With investing, reaching your goals requires a strategy that will give your money the best chance to grow without recklessly risking more than you should. One investment strategy that can help you do this is often called “asset allocation”.
What is asset allocation and what does it mean for your portfolio’s potential?
To give you a better idea of how asset allocation works and how it can help with your long-term investment results, we’ve answered some of the most common questions about this often misunderstood strategy.
Q. What is Asset Allocation?
Asset allocation is a risk management strategy of spreading your assets out across different types or classes of investments.
This includes low-risk/low-reward investments like savings accounts, higher-risk/higher-reward investments like stocks, as well as many other asset classes (i.e. precious metals, bonds and real estate).
The idea behind asset allocation is simple: instead of putting all of your eggs in one basket, you carefully spread out your risks and give yourself a better chance of coming out ahead.
How does that work? Careful asset allocation can give your portfolio a safety net – or better yet, multiple safety nets – in case one investment category performs poorly.
For instance, let’s say the stock market takes a tumble… your allocation in cash and cash equivalents (i.e. Treasury bills or Certificates of Deposit) are there to back you up.
What if inflation or currency exchange rates impact your cash investments? If you’ve allocated your investment money to include commodities, precious metals, inflation-adjusted bonds or real estate you’re more likely to come out unscathed.
Ideally, your assets are allocated into investments that have different or opposing levels of risk. If one asset category is in decline, hopefully one or more of the others will be going up.
The asset allocation strategy can also give you the protection of lower-risk investments in case your higher-risk investments go into a slump. This can also give your investment money more chances to grow if one or more of your other investment classes are rallying at the same time.
Q. Who Needs Asset Allocation?
Asset allocation is suitable for every serious investor. It’s really useful as part of your longer-range investment planning. Make sure you have a plan before beginning to invest or trade.
Even if you’re just getting started in investing and you’ve decided to speculate with a few hundred dollars in a single stock, be aware that asset allocation is a more prudent way for an investor to grow their portfolio over time while carefully managing the downside risks.
The more aggressive your investment goals, the more essential it is to use asset allocation to rein in the chances for suffering unacceptable losses.
Simply stated, any investor who wants to give their money the opportunity to grow without putting everything on the line needs to make asset allocation part of their investing strategy.
Q. How is Asset Allocation Different from Diversifying?
Asset allocation and diversification rely on the same principle of protecting your assets by distributing them among a wide enough variety of investments.
So how do they differ? Asset allocation refers to investing in different asset classes – stocks, bonds, cash, precious metals etc. Diversification has to do with spreading your money out within a category, such as the number of different stock positions you own or the variety of industries you invest in instead of investing in a single stock or just one industry.
Q. Is Asset Allocation Risky?
All investment strategies involve a certain amount of risk. Using an asset allocation strategy will involve risk that depends on a number of factors.
One factor involves how you were investing before allocating your assets. If you were investing solely in high-risk stocks, then asset allocation is a safer, less risky strategy, since much of your money will now be spread out into different investment categories with varying amounts of risk.
On the other hand, if you’re previous investing was limited exclusively to very low risk investments like U.S. Treasury bills, then including higher-risk investments like stocks in your portfolio is adding a new element of risk.
Remember though, it also gives your investment assets more opportunity for growth and keeping up with the cost-of-living. This is especially relevant during a time of inflation.
Also, the level of risk involved in asset allocation depends on the model you follow. Some models will put a higher percentage of your money into higher-risk asset classes, while others will take a more conservative approach with a focus on lower-risk investments.
Q. What’s the Best Model?
The best asset allocation model will vary from one investor to another, depending on their financial goals, and risk tolerance.
Determining the appropriate asset allocation model for your financial goals is a complicated task. You may want to consider the use of an independent, certified financial planner to assist you.
There are also a vast array of investment products that facilitate asset allocation such as a large family of mutual funds, lifecycle funds, to which you’d include U.S. Treasury securities, and perhaps other asset classes. Also, ask your brokerage firm if they have online asset allocation tools you can use.
Basically, you’re trying to select a mix of asset categories and to decide what percentage of your investment assets you’ll allocate for each category. You’ll want an asset allocation that has the highest probability of meeting your goals at a level of risk you can live with.
For the part of your assets that are invested in stocks and stock options, you’ll want to utilize a system that will help you to control the amount of risk you’re exposed to. That’s why we created TradeStops 2.0!
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