The Role of Asset Allocation in Investment Success
Attaining financial goals through asset allocation strategies is the cornerstone of investment success, yet this process can be tricky and time consuming.
Asset allocation is the practice of selecting investments based on risk tolerance, investment goals, time horizon and diversification across asset classes such as stocks, bonds/sukuks, cash and gold.
Diversification
Diversification can help protect against “putting all your eggs in one basket”. Should a particular stock, sector or asset class suffer declines, others could provide respite that can offset losses.
Diversification can also mitigate investment risk through correlation. When invested together, investments with low correlation tend to fluctuate independently of one another and can help smooth out large swings in portfolio values.
Your ideal asset allocation depends on a range of factors, including your goals, time horizon and risk tolerance. For instance, investing for retirement several decades away allows for more risk taking because there will be enough time to recover from any setbacks or market downturns. But as retirement nears closer, more conservative investments such as bonds or cash may provide added protection from outliving assets.
Stability
Stocks and bonds provide the foundation of any investment portfolio, but their levels of risk can vary widely between asset classes – making it nearly impossible to predict which assets will outshine each other from year to year.
Investors should use their personal investment goals, time horizon, and available funds to determine an ideal asset allocation. Furthermore, it is essential that they evaluate their risk tolerance; often this cannot be fully appreciated until experiencing a bear market with their savings.
Financial experts often consider asset allocation one of the most vital decisions an investor will ever make in his or her lifetime. Working with a financial advisor to establish an initial asset allocation and adjust as life changes occur can help investors avoid common pitfalls that can undermine their financial goals.
Growth
Financial advisors have long advised their clients to create a balanced portfolio consisting of stocks and bonds. 60% invested in stocks can lead to strong growth while 40% in bonds can serve as protection in bad years when stocks fall in value due to falling interest rates (though bonds often rise).
Asset allocation refers to the mix of stocks, bonds and cash/cash-like assets in your portfolio that best matches your investment goals and risk tolerance – which may change over time. For instance, if saving for college is still years away for your child you might opt for more aggressive allocation.
Investment growth potential can be affected by many external forces, including market environment factors, supply-chain issues, COVID-19 shutdowns, political events and economic considerations, among others. Discipline is essential in maintaining your asset allocation plan over the course of an investor career and regularly rebalancing portfolio.
Rebalancing
Rebalancing is the practice of selling off investments that have grown too quickly while increasing those that have depreciated too quickly to restore a portfolio’s original asset allocation percentages and is considered essential to effective investing.
Rebalancing may seem straightforward in theory, yet its implementation can often prove challenging. Investors may be tempted to let gains ride when markets perform well; however, investing regularly in undervalued assets through sales of high-performing ones and purchases of underperforming ones can reduce risk while potentially improving long-term returns.
The exact percentages of each asset class depend on each investor and often depend on factors like time horizon and risk tolerance. The goal should be to strike a balance among stocks, bonds and cash that helps investors safely navigate market fluctuations while reaching their destination.
