Creating an appropriate asset allocation for your investment portfolio can be tricky. For many of us, there are several very important factors we should incorporate, such as our personal risk preferences, our time horizons, and our financial targets. The incorporation of these factors, among others, will allow us to choose asset classes that will most likely help us to achieve our ultimate investment goals. But, where do we even start?
For new investors specifically, it can be hard to wrap your mind around the whole idea of setting limits for what kinds of assets you should and should not pick. One good way to view this strategy is to think about establishing your asset allocation in the same way that you would think about budgeting. If you lay out parameters for yourself, it will be much easier to keep a consistent plan and achieve your goals in the long run. Let asset allocation stand as your map for navigating through the various fields of investment decisions.
Once you agree to stick to a target asset allocation (which you can always change along the way, if need be), you will be faced with another important question: what asset allocation strategies are even feasible? The answer to this question will vary significantly depending on your goals, but the short answer is that there are many widely accepted asset allocation strategies that investors use each day. Any planning method you can think of is a good start, as long as you can align it with your goals! To get your mind rolling on your own asset allocation, here are 4 of the most commonly used methods for establishing a basic asset allocation:
This strategy reflects the expected rates of return for each asset class you choose. For example, if stocks have historically returned 8% per year and bonds have returned 4% per year, you could expect a portfolio split between the two asset classes to return around 6% in a year. Depending on your time horizon and goals, then, you could weight each asset class differently in order to meet the correct projected return for your portfolio. So, if you wanted a return of 7% in this example, you would need to allocate your money more heavily towards stocks than bonds – about 75% stocks and 25% bonds. Further, if you hoped that your portfolio would return more than 8% (or more than the average return of your highest returning asset) you might have to consider factoring in other asset classes that typically yield even higher returns to achieve that goal.
For some investors, sticking exactly to strategic asset allocation might be hard. If so, we present tactical asset allocation. Think about this strategy as a strategic asset allocation’s more active older brother. In this tactical asset allocation, you set the same goals as you would in the strategic asset allocation we just explained above, but you also allow yourself to deviate slightly from your plan when you see real, short-term opportunities. The hardest part about this asset allocation strategy is knowing when it is time to cut back on a short-term opportunity and rebalance your portfolio to reflect your original strategic asset allocation.
This strategy starts out with a strategic asset allocation, but again deviates slightly from that original plan. With a constant weight asset allocation, investors aim to rebalance their portfolios every now and then (at least once a year) in order to reflect the returns of each of the asset classes they include. For example, if one asset class has gone up significantly over the course of a year and now constitutes 50% of an investor’s portfolio, when the investor planned to only allocate 40% of their portfolio to that asset class, the investor would sell some of the asset. On the other hand, if an asset has decreased in its total share of the portfolio, the investor would buy more to return it to its initial asset allocation.
With this strategy, an investor sets a base portfolio value. This value becomes the lowest possible value for the portfolio, beyond which the investor will not let his or her portfolio’s value fall. Then, the investor takes a very active role in regulating his or her investments to try and produce the highest returns possible. In the case that the portfolio’s value did drop below the base value, the investor would allocate all of his or her money to risk-free assets, such as bonds, and develop a new asset allocation plan. This strategy works best for more experienced and risk-averse investors, who feel that they need to constantly monitor their portfolios.
Overall, choosing an asset allocation strategy is something that is highly dependent on the investor’s personal investing goals. While all of the strategies laid out above are popular, they are also malleable and can be molded to fit your own individual preferences. Once you’re ready to invest, you might want to start thinking about what strategy is right for you – remember, it will be a lot easier to reach your end destination if you make yourself a map!