“If you could remember only one thing about investing, it should be to diversify your investments.”
When it comes to reducing your exposure to risk, there are two proven strategies you as an investor should apply. The first is asset allocation. The second is diversification. When used in tandem, these two strategies can be very effective in protecting the value of your financial investments in the event of a market downturn.
In this section, you’ll…
- Learn what asset allocation is and how it can reduce risk
- Be introduced to five asset allocation models and their characteristics
- Understand the determining factors for which asset allocation model is right for you
Asset allocation is the technique of diversifying an investment portfolio among different types of asset classes such as stocks, bonds, and cash equivalents.
Different asset classes behave differently when factoring in risk and reward. Stocks offer the highest return but carry the highest risk of loss. Bonds generate more modest returns but offer more stability than stocks. Cash equivalents such as money-market funds carry low rates of return but the principal investment is always protected.
Since different asset classes (stocks, bonds, cash) generally react differently within similar market conditions, combining these different asset classes can often produce an attractive risk-versus-return trade-off. More importantly, asset allocation strategies allow you to achieve the optimal blend of risk and reward that’s right for you.
How each investor chooses to allocate their investment dollars depends on four basic factors:
- individual investment goals
- tolerance to risk
- investment time horizon
- available funds to invest
Each unique combination of these factors corresponds to a particular risk profile for each and every investor.
The U.S. accounts for just over one-half of the world’s total stock market value. Asia and the Far East account for around 14 percent of total stock market values worldwide. Europe and Australia make up 30 percent of the total value of the world’s stock markets.
The following five asset allocation models take into account the traditional investor risk models that range from conservative to aggressive. You can use these models to begin considering what asset allocation strategy is appropriate for you.
Capital Preservation Model
|· Investment Objective:||preservation of capital|
|· Risk Level:||low|
|· Avg Annual Return:||3% – 5%|
|· Important To Note:||After inflation is accounted for, returns could be very low or even negative. Trade-off is high liquidity and security of principal investment.|
|· Investment Objective:||income with preservation of capital|
|· Risk Level:||low to moderate|
|· Avg Annual Return:||4% – 6%|
|·Important To Note:||Income model assumes slightly more risk but is capable of delivering a modest and ‘real’ rate of return after inflation.|
Income Growth Model
|· Investment Objective:||safety of principal with growth of capital|
|· Risk Level:||moderate|
|· Avg Annual Return:||5% – 8%|
|· Important To Note:||Income-growth model accepts potential loss in capital due to moderate risk incurred and opportunity for higher return.|
|· Investment Objective:||growth of capital with safety of principal|
|· Risk Level:||moderate to aggressive|
|· Avg Annual Return:||7% -10%|
|· Important To Note:||Growth model accepts higher risk due to the type and concentration of investments held. As a result, portfolio adjustments are more actively made.|
The crash in 1929 cut the value of stocks by 12.8%. The crash of October 1987 cut the value by 22.6%. Best year of the Dow Jones was 1915 when it rose 81.7%. Worst Year was 1931 when it crashed by 53.7%. The Dow Jones first crossed the 1,000 level, in trading, in 1966 but didn’t close above 1,000 until November 1972.
Aggressive Growth Model
|· Investment Objective:||growth of capital|
|· Risk Level:||aggressive|
|· Avg Annual Return:||10% or greater|
|· Important To Note:||Aggressive growth model accepts possibility of wide variances in performance results year-to-year due to high risk/high return potential. Characteristic of having very concentrated portfolio positions with frequent portfolio changes being made. Careful management required.|
Stick With Your Allocation
The allocation model you choose should be governed by factors such as your investment objectives and your risk tolerance. Only when there’s a change in either of these variables should you make changes to your allocation strategy or model.
For example, as you age and approach retirement, it’s only logical to reduce the level of risk in your portfolio. Similarly, if a portion of your investment dollars is required in the short or immediate-term, the level of risk behind your investments should also be reduced to ensure the value of your portfolio does not decrease.
The most common mistake made by investors is to adjust the allocation mix of their portfolio monthly, weekly, even daily due to ‘hot’ stocks in the headlines or short-term declines in their portfolio. It may provide near-term psychological comfort but more chances than not, it can generate below average returns.
THE RULE OF THUMB TO FOLLOW: revisit your portfolio approximately every two years to ensure your asset allocation model reflects your desired mix based upon your individual investing profile, which should take into account your present investment goals, time horizon and risk tolerance.
Key Learning Points
- Asset allocation is one of two effective risk-reducing strategies to protect your investments and increase potential returns.
- Asset allocation is the method of diversifying your investments across major types of asset classes such as stocks, bonds, cash and cash equivalents.
- There are typically five allocation models available with each offering an increase in the level of risk versus reward: Capital Preservation, Income, Income-Growth, Growth, and Aggressive Growth.
- The allocation model you choose should be governed by factors such as your investment goals, tolerance to risk, investment time horizon, and available funds to invest.
- You should revisit your portfolio approximately every two years to ensure your asset allocation model reflects your desired mix and individual investing profile.