Diversifying your portfolio is good. Diversifying your portfolio using asset allocation? Better.
This is the way an investor distributes funds in his portfolio across various asset classes.
The purpose of asset allocation is minimizing the amount of risk you’re exposed to while helping you reach your financial goals. This means that you need to be familiar with the characteristics of the asset classes, especially their risk and returns potential.
For example, fixed-income securities backed by the government fit even a conservative risk profile but aren’t likely to give you very high returns. On the other hand, certain stocks may shoot up (or down) in value – hence the saying: “The lower the risk, the lower the return; the higher the risk, the higher the return.”
Asset allocation basically gives you the best of both worlds. It tempers the effects of volatility from high-risk assets on your portfolio, while at the same time giving you some sort of stability from conservative outlets.
Allocation models
Learning the 4 basic allocation models can help you set an asset allocation that’s right for your needs and situation. These models are named according to the intent of the portfolio that is based on them.
- Capital preservation – This model can be followed if you want to maintain the value of your investments. It can be considered by people with a short time horizon (usually within the next 12 months) and who are comfortable with low returns in exchange for minimal risk.
The allocation for this model is 70% to 75% in fixed-income securities, 15% to 20% in equities, and 5% to 15% in cash and cash equivalents.
- Income – As the name suggests, this model can fit you if you want stable and consistent income from your investments. It can be considered by people who want to safeguard most of the investment’s value but are willing to take on a little more risk in return for the chance of getting a little more profit.
For this model, the allocation is 55% to 60% in fixed-income securities, 35% to 40% in equities, and 5% to 10% in cash and cash equivalents.
- Growth – This model is intended for portfolios with the potential to rise in value over time. It can be considered by people who are willing to take on a lot of risk and have a long time horizon.
A portfolio that follows this model will have an allocation of 65% to 70% in equities, 20% to 25% in fixed-income securities, and 5% to 10% in cash and cash equivalents.
- Balanced – This model aims to create a portfolio that balances risk with potential returns. It works best for people with a time horizon of more than 5 years and at least a moderate risk profile.
The allocation for this model is usually divided equally between stocks and bonds, or 60% in stocks and 40% in bonds. For liquidity purposes, a 5% to 10% portion can be allotted to cash and cash equivalents, with the rest comprising 50% to 55% equities and 35% to 40% fixed-income securities.
Pooled funds
An easy way to do asset allocation is to put your money in pooled funds, which are managed by experts who take care of the allocation, research and decisions for you.
Most of these funds are made according to 1 of the 4 models mentioned earlier. You can find out the full details by checking out the Key Information and Investment Disclosure Statement (KIIDS), although you might also be able to tell the type from what it’s called. For example, it may have “balanced” or “growth” in the name.
If you prefer to have full control over your assets and investing decisions, a pooled fund might not be the right choice for you. But if you’d rather leave the decisions to an expert, this type of investment is definitely worth considering.
