Using Asset Allocation to Minimize Risk

One of the best ways to manage a portfolio is to allocate your assets in a way that avoids putting all of your eggs in one basket according to stock market experts. Asset allocation is the process of allocating capital to different types of investment instruments, as well as, specific strategies that are used to generate robust returns. Investment managers use allocation as a way to design a portfolio that will meet their targeted expectations of returns.

The process of asset allocation involves distributing capital to a portfolio targeting different asset categories, such as stocks, bonds, commodities, alternative investments and cash. The process creates a mix of assets that are invested based on an investors risk reward profile.

What Determines Asset Allocations

Allocations are generally determined by an investors risk reward profile, as well as their investment time horizon.  The higher the risks associated with an asset the higher the expected return.  The goal is to create a basket of assets that are generally uncorrelated to each other in an effort to generate returns in all types of market environments.

For example, an investor that is above retirement age would likely have a lower tolerance to risk, and therefore might be more interested in income producing financial instruments compared to instruments that will produce capital gains.

Asset allocation is one of the main determinants in finding the appropriate mix of financial products that will perform to target assumptions over time.  Allocating funds to very risky assets such as high beta stocks will generate a portfolio with high volatility and high expected returns.  A portfolio that is all cash and cash equivalents will be very safe, but generate very low returns.

Allocation analysis allows investors to create a mix of financial assets that will perform to expectation over the course of time. Historically, major asset classes have been uncorrelated, which means their movements do not perform in tandem. Holding riskier assets, such as common stocks, as well as, income producing assets, such as bonds, should generate returns in all type of market environments.   Bonds generally are less volatile than stocks and are usually purchased during economic weakness.

Asset allocation is constructive because it can determine if an investor will meet their financial target. If a portfolio is conservative, the upside is limited.  If an investor is looking for robust capital gains, they are likely to fall short of their expectations.  If a portfolio on the other hand is very risky, investors could lose a substantial portfolio of their capital during an adverse market move.

Principles of Allocation

Applying asset allocation principles to an investment portfolio will not only decrease the effects of adverse market movements, but it will help you take advantage of the inherent opportunities hidden within the chaos.

For instance, during a market crash, if you applied asset allocation to your investments, you would have many of your investments in secure assets that would be untouched by the market crash. Therefore, when others are wiped out, and equity and property prices are at all time lows, you can use some of your secure investments to snap up these bargains, thus reaping substantial profits when the market later recovers.

Allocation is a form of risk management, which will not only assist in generating solid market gains, but will also mitigate market and credit risks.  There are numerous types of processes that are used to allocate a portfolio.  Allocation can range from a discretionary style in which an investor uses guidelines to allocation capital, to statistical analysis where investors use a covariance matrix to find the best historic portfolio.

Changing Allocations

The most common reason for changing your asset allocation is an alteration of your time horizon. For example, if your investment goal was retirement in 20 years, from a date, when 10 years have passed, your time horizon has change from 20 year to 10 years.

Most investors typically do not change their asset allocation based on the relative performance of asset categories instead they rebalance, meaning they shift their capital to reflect better performing assets.

The concept of rebalancing is resetting your portfolio back to your original asset allocation mix. This is important because over time some of your investments can grow differently from your original investment goals.

Asset allocation is key to generating wealth over a long period of time and investors should venture to understand the theories behind successful allocation in an effort to maximize gains and minimize risks.