Importance of Proper Asset Allocation
What is Asset Allocation?
Often time investors see fluctuations in their portfolios due, in part, to something called proper balancing and asset class weights. Essentially it boils down to what is the asset allocation of the portfolio. Asset allocation is defined as an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon. As noted, there are three concerns that shape a proper asset allocation; goals, risk and time. Let's explore them...
Whenever someone is looking to start their investment journey, they have to ensure that they set proper goals and outcomes. You must ask yourself; what am I looking to do? What do I want the outcomes to be? Why am I investing, etc.…? Understand that while there are goals that overlap from person to person (like retirement, college savings, etc.); essentially goals are still very specific to the individual or entity creating them. In the business management world, many organizations have adopted goals based acronym called S.M.A.R.T. (Specific, Measurable, Attainable, Realistic, Time-bound). This process for goal making is widely used to create and sustain appropriate goals within an organization. The same should go for someone's investment goals. So let's break this down a bit. An example of an S.M.A.R.T. goal for someone in the consulting business would be something like:
I will acquire three new clients for my consulting business within two months by asking for referrals, launching a social media marketing campaign and networking with local businesses. This will allow me to grow my business and increase my revenue.
Having a specific goal will help to ensure that you stay on track as you begin and/or enhance your investment life.
Risk tolerance is an investor's ability or willingness to accept declines in the prices of investments while waiting for them to increase in value. While having goals is important, truly understanding your level of risk tolerance is also essential to your portfolio. Often times, people are misdiagnosis their level of risk they are willing to withstand. Most investors feel pretty good when the markets are up and their portfolio balances are steadily growing. However, when disaster strikes they run. For example: In the midst of the one of the worst financial crisis our country faced, the S&P 500 was down a whopping 37%. Portfolios that had equity exposures probably lost 37% of its value. However, those who stuck it out saw an increase in their portfolio value of about 26.6% in 2009. This would have brought their effective potential loss to about 11% year over year. Unfortunately, many people pulled out of the market due to its decline and had a realized loss of about 37% to their portfolios. I submit to you that if you understand how the markets work and you have appropriately assessed your risk, the decisions you make in times of crisis will be different. All in all, the rule of thumb is more risk more reward, less risk less reward. Be sure to know where you stand when it comes to risk.
Time Horizon is the length of time over which an investment is made or held before it is liquidated. Time horizon is important because it dispels when you will need to actually access the funds for daily expenses or to utilize for the goals that you set. Typically if this is for retirement the time horizon could be more than ten years from now, depending on the investor's age.
As you can see having the appropriate asset allocation is extremely important to attaining the desired outcome in your investments. You have to ensure that you create SMART goals for your financial life. Ensure that you have evaluated the level of risk you are willing to take. Then understand the appropriate time that will allow your investments to grow and ultimately provide you with more buying power in the end.