Understanding Asset Allocation

Published on 27th July 2008

A portfolio is essentially the sum of all of your different investments. These investments will probably include stocks (investments in individual businesses); bonds (investments in debt that are designed to earn interest); and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices.

Building a winning portfolio is dependent on a number of factors, designed according to your needs and goals. Your ideal portfolio may not be the same as another investor's. You must carefully study your finances and options in order to be successful.

One of the most important steps to building a successful portfolio is properly dividing assets among different types of investments. The most important asset classes are stocks, bonds, and cash. As these investments perform differently depending on economic conditions, a good balance can keep a portfolio strong in a wide range of economic situations. In this sense, asset allocation may be the most important form of diversification. Also, asset classes carry varying amounts of risk, meaning that the best allocation will depend on a range of factors related to an individual's investing profile.

When putting together an asset allocation plan, it is most important to consider investing goals, risk tolerance, and time horizons. The three factors are closely related. They allow you to map out how much money you will need at certain points in your life and how much uncertainty you can tolerate in moving from one life stage to the next.

Investing goals are closely tied to age and family situations. Younger people can generally tolerate more investment risk because they can afford to wait and make up the difference later. Time horizons are the lengths of time until the invested money will be needed. Common examples are the time a child starts college or one retires.Again, long time horizons allow for riskier investments because a temporary downturn will not ruin the long-term plan.

Once you have decided your time horizons and the level of risk you're comfortable with, the next step is to determine the investment options that are best for your profile. Higher risk opens the door to greater rewards, but those potential rewards are worthless if they are missing when the money is needed.

Stocks offer the best long-term growth prospects to investors. In the long run, they have outperformed nearly all other investments, but they are also quite volatile, making them a riskier investment. Over shorter periods of time, stocks can lose a great deal of value. The impressive performance of stocks is based on looking at stocks as a whole. Individual stocks may not keep up with the market as a whole; they may become completely worthless (for example, if the company declares bankruptcy).

Bonds are a safer investment with less spectacular returns over time. The lower returns are the cost of removing a great deal of volatility from the equation.Cash investments such as money markets are the safest investments, and, as expected, deliver the lowest returns. Assets should be divided among these major groups and possibly some more specific ones like real estate or international investments in order to create a portfolio that meets your specific needs in terms of risk and reward.

In order to get some help with asset allocation without having to hire a financial adviser or become an expert, many investors turn to mutual funds. Asset allocation funds offer different mixes of stocks, bonds and other investments to fit different investing profiles. Alternatively, mutual funds can be used to provide diversification within different asset classes. You can simply divide your money among stock funds, bond funds and money market funds in the proper ratios.

Asset allocation funds are constantly rebalanced to reflect the intended allocation among the asset classes. For investors using individual funds or picking their own investments within the classes, it is important to regularly rebalance the portfolio to reflect the ideal allocation that was initially determined. For example, if your stock investments take off, you may find yourself with a greater than desired portion of your assets in stocks. At that point, you are taking on more risk than you would like to because the value of  the portfolio has increased. The opposite can occur if one portion of a portfolio underperforms. Of course, the tendency would be to abandon the underperforming asset class, but it is important to return it to the desired level of prominence in order to remain true to the initial goals and time horizons.

In order to rebalance, funds must be shifted from over-weighted areas of the portfolio to under-weighted ones, restoring the original mix of asset classes. Alternatively, new money can be invested in the under-weighted classes or money can be removed from the over-weighted classes, increasing or decreasing the total value of the portfolio respectively.

By Asha Hirsi

Emerging Africa Capital, Licenced by The Capital markets Authority.


 


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