Asset allocation is the process of selecting a mix of asset classes that closely matches your financial profile in terms of your investment preferences and tolerance for risk. It is based on the premise that the different asset classes have varying cycles of performance, and that by investing in multiple classes, the overall investment returns will be more stable and less susceptible to adverse movements in any one class.
All investments involve some sort of risk, whether it’s market risk, interest risk, inflation risk, liquidity risk, and tax risk. An individualized asset allocation strategy seeks to mitigate the risks of any one asset class though diversification and balance.
In summary, the impact of asset allocation on returns depends on your investing style. For the long-term, passive investor, the asset allocation decision is by far the most important. For the short-term investor who trades more frequently, invests in individual securities, and practices market timing, asset allocation has less of an impact on returns. The impact of asset allocation on performance is directly correlated with investment style.
Individual Asset Allocation Strategy
When done properly, an your allocation of assets will reflect your desired goals, priorities, investment preferences and tolerance for risk. Asset allocation is an individualized strategy, so there really is no perfect mix of assets. Your strategy should be built on the careful consideration of the key elements of your financial profile:
Investment Objectives: What it is you hopes to achieve using your investment dollars – improve current lifestyle; achieve capital growth; fund a specific goal, such as a college education
Risk Tolerance: This reflects your comfort level with market fluctuations that can result in losses. Inflation risk and interest risk need to be considered as well.
Investment Preferences: You may prefer one asset class over another based on a certain bias or interest towards the characteristics of that class.
Time Horizon: The length of time you are willing to commit to achieving your objectives.
Taxation^: Investing in a mix of asset classes will have varying tax consequences.
An Evolving Strategy
A sound asset allocation strategy includes periodic reviews.
About the only certainty when it comes to the financial markets is that they will change, and so will your financial situation. Through market gains and losses, a portfolio can become unbalanced and it may be important to make adjustments to your allocation. As you move through life’s stages your needs, preferences, priorities and risk tolerance change and so too must your asset allocation strategy.
Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification.
To learn more about asset allocation, diversification, and how they fit into your overall financial strategy.
Asset allocation does not ensure a profit or protect against a loss, but is intended to help you manage your goals and risk tolerance.
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