One of the most important aspect of investing is the principle of asset allocation. And to be honest, not enough beginning investors take it seriously.
What they don’t realize is that over the long run, this simple principle could be one of the most important drivers of their investment strategy.
In fact, one study found that 90% of the variability of average total returns earned by balanced mutual funds over time was the result of their asset allocation strategies. This alone proves how valuable this principle can be!
So what is asset allocation?
In essence, asset allocation is the way in which investments are weighted in a portfolio among different types of assets classes. This allows you to diversify your funds across a broad range of risk and return characteristics to maximize your return.
For example, let’s say you own a fruit stand. Which one of the following combinations do you think would increase your chance of profitability?
In this scenario diversifying the fruits invested in increases your chance of selling something and reaching profitability.
While this is a simple, and not entirely representative, analogy; it should give you a better idea of the power of diversification through asset allocation.
What counts as an asset class?
Traditionally, the major asset classes are stocks, bonds and money market instruments.
However, personally, I’ve expanded the definition based on the various investment opportunities that are now available.
Here’s a quick list of other asset classes I personally allocate funds to
- Building/buying websites
- Cryptocurrencies (Bitcoin as well as diversifying across various altcoins)
- Rental properties
Why is asset allocation so important?
At first it may seem like a simple principle, but proper asset allocation can truly be a portfolio-saver. The diversification across several asset classes ultimately lowers the overall risk by increasing the probability that, if and when one investment is falling, the return of another may be rising.
But, as with anything in investing there are no guarantees and asset allocation doesn’t automatically guarantee you won’t lose money. But it can improve your odds greatly.
What’s the right asset allocation for me?
Asset allocation ultimately depends on your risk tolerance. So, it will change over time as your risk profile changes based on age, life situations, etc.
For example, a 20 year old can afford to take on higher risk than an individual nearing retirement, as they’ll have a longer runway to recoup any losses that may occur. On the other hand, the individual nearing retirement would want to focus on protecting the capital they’ve spent their entire life building up.
So, while the 20 year old may allocate 70% of their assets into aggressive high growth stocks, the individual nearing retirement would most likely want to start shifting their allocation into bond and money market holdings.
However, age is only one factor. Employment, kids, family obligations, etc are all other variables you need to consider when deciding on what asset allocation will work for you.
At the end of the day, it all depends on what works for you. Keep learning, keep experimenting and success will find itself.
What asset allocation strategy do you personally follow?