Asset Allocation – Smart Investing

Asset allocation is the process of choosing among possible asset classes.

A large part of financial planning consists of finding an asset allocation that is appropriate for a given investor in terms of their appetite for and ability to shoulder risk. This can depend on various factors; see investor profile. Asset Allocation is the product of an examination of an investor’s needs and objectives. Asset allocation, done well, is a plan to invest in assets or asset classes which will best meet the needs and objectives of the investor. Investors seeking high returns and willing to expose their investments to an elevated amount of risk will allocate to equity(ownership) investments. Investors seeking stability and income will allocate to debt investments. Most investors, particularly personal investors, will find mixtures of equity and debt investments most nearly meets their needs. Asset Allocation can be practised by optimization techniques, minimizing risk for a given level of return or maximising return for a given level of risk. It also can be accomplished as goal based investing.

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 Justification

Asset allocation is based on the idea that in different years a different asset is the best-performing one. It is difficult to predict which asset will perform best in a given year. Therefore, although it is psychologically appealing to try to predict the “best” asset, proponents of asset allocation consider it risky. Experts in the field note[citation needed] that someone who “jumps” from one asset to another, according to whim, may easily end up with worse results than does someone following any consistent plan.

A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor’s wishes in terms of amount of risk and possible returns.

In this respect, diversification has been described as “the only free lunch you will find in the investment game”. [1] Academic research has painstakingly explained the importance of asset allocation and the problems of active management (see academic studies section below). This explains the steadily rising popularity of passive investment styles using index funds.

Although risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships (like correlation and variance) that existed over some past period. Expectations for return are often derived in the same way.

When such backward-looking approaches are used to forecast future returns or risks using the traditional mean-variance optimization approach to asset allocation of modern portfolio theory, the strategy is, in fact, predicting future risks and returns based on past history. As there is no guarantee that past relationships will continue in the future, this is one of the “weak links” in traditional asset allocation strategies as derived from MPT. Other, more subtle weaknesses include the “butterfly effect“, by which seemingly minor errors in forecasting lead to recommended allocations that are grossly skewed from investment mandates and/or impractical—often even violating an investment manager’s “common sense” understanding of a tenable portfolio-allocation strategy.

[edit] Asset allocation strategies

There are three basic types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification: strategic, tactical, and core-satellite.

Strategic Asset Allocation – the primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.

Tactical Asset Allocation – method in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains.

Core-Satellite Asset Allocation – is more or less a hybrid of both the strategic and tactical allocations mentioned above.

Systematic Asset Allocation is another approach which depends on three assumptions. These are-

  • The markets provide explicit information about the available returns.
  • The relative expected returns reflect consensus.
  • Expected returns provide clues to actual returns.

[edit] Examples of asset classes

 

As in eveything in life never put all your eggs in one basket. There is nowhere else that this principle is more valuable and important than in the allocation of your assets.

The three areas that compose most of one’s assets are:

Real Estate

Cash Savings

Equity

In order to make the right investing decision it is wise to understand the above three areas.

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