There are two categories of asset classes:
- Traditional asset classes include stocks, bonds, and cash.
- Alternative asset classes include mutual funds, commodities, real estate, private equity, hedge funds.
The third step is asset allocation, in which the financial planner develops a strategy of how much money to invest in each asset class for you to achieve your return objective at a risk level that you are able and willing to accept. The premise of asset allocation is that each asset class has a different risk and return characteristic, thus providing the investor with risk diversification benefits.
For instance, a 20 percent stock/80 percent bond portfolio will provide lower risk and return and a more regular cash flow than an 80 percent stock/20 percent bond portfolio. It is also important to note that the latter is a riskier portfolio and is more suitable for young individuals in their 20s who have a longer time horizon and can tolerate stock market volatility. On the other hand, the first portfolio is more suitable for individuals who are nearing retirement and cannot withstand a drastic decline in their portfolio.
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So why is asset allocation so important for investors?
As explained above, the most significant benefit of asset allocation is that it provides diversification and helps the investor manage the risk of his/her portfolio. While most people do understand this concept, they would still focus on which investment would outperform or whether equity markets would trend up or down. Although these are important considerations, many professional money managers believe that asset allocation is the most important decision for the investors.
According to Sheryl Rowling, a certified public accountant and principal at Rowling & Associates, with asset allocation strategy, "you have different pieces of the pie, and all those pieces react differently to different occurrences in the market." She added, "Some pieces go up while other pieces go down, so you will still get the average return of the market, but you won't have the extreme ups and downs."
The most important factors in determining the asset mix are risk tolerance and time horizon. An individual with a longer time horizon and higher risk tolerance should automatically tilt his or her portfolio toward stocks. According to a traditional rule of thumb, the percentage of stock allocation should be equal to 100 minus your age. So if your age is 25, then 75 percent of the portfolio should be allocated toward stocks. Over the years, many experts have expressed concern over using this rule as they believe it results in extremely conservative portfolios for retirees.