Asset allocation is the process of allocating financial resources (wealth) among a number of asset classes such as cash or cash equivalents, bonds, stocks, mutual funds, real estate as well as alternative investments like exchange traded funds (ETFs), hedge funds or private equity.
With the asset allocation decision an investor attempts to optimally balance reward versus risk by determining the proportion of each asset class in his portfolio. The asset allocation decision depends on many factors such as the investor’s attitude towards risk, his investment horizon, and the available investment opportunities.
Finance professionals and academics claim that asset allocation is the most important factor in determining a portfolio’s return and volatility. This is because asset classes tend to perform differently during different stock market phases and macroeconomic conditions. Therefore, an investor can reduce his portfolio risk since each asset class performance is not perfectly correlated with the performance of the other asset classes. The most characteristic example is the performance of stocks versus bonds. It is well known among investors and financial professionals that when stocks rise, fixed income securities (bonds) usually fall.
Diversification is critical if you want to protect your investment portfolio from rare events with disastrous consequences. Although it would be great to know for sure whether stocks or bonds will outperform over the next year, financial markets are very uncertain. The uncertain nature of financial markets is the reason why we should not put all the eggs in one basket.
An investment portfolio should not be concentrated to stocks. Despite the fact that until the end of the previous century stocks proved to be much more rewarding than bonds, there were many occasions when stock market performance was very disappointing. Moreover during the last decade stock investors have suffered dramatic changes in their wealth level because of the extremely volatile equity markets. Nowadays stocks do not seem to be so attractive as they used to be.
In addition, a stock portfolio is not appropriate for investors who seek an income stream with low volatility. A widow, for instance, having two million dollars to invest with no additional sources of income would optimally place a substantial portion of her wealth in fixed income securities which, under normal circumstance, can generate a steady flow of income. The widow’s main objective is not to increase her wealth, but to form a low risk portfolio with dividends and coupon payments which will enable her to meet her financial needs and preserve her lifestyle. On the contrary, a young entrepreneur in his late thirties, will probably be more interested in how to maximize his portfolio growth rate. A young individual with decent income has a long investment horizon and thus can afford more risky as well as more rewarding investments.
Asset allocation seems to be the principal determinant of both return and risk in investment portfolios. A number of researchers have concluded that the asset allocation decision accounts for the biggest part of portfolio performance, while other steps of the investment process such as market timing and stock picking account for a relatively small part. However, there is still much debate about the methodology and the result of these research papers. The main conclusion of this line of research is that an investor should make the asset allocation decisions in a cautious manner. A stock investor should base his asset allocation process on clear objectives, a proper investment horizon and realistic expectations about each asset class risk and return components.
StockTradingCollege.com, Stock Trading and Investing for Beginners
With the asset allocation decision an investor attempts to optimally balance reward versus risk by determining the proportion of each asset class in his portfolio. The asset allocation decision depends on many factors such as the investor’s attitude towards risk, his investment horizon, and the available investment opportunities.
Finance professionals and academics claim that asset allocation is the most important factor in determining a portfolio’s return and volatility. This is because asset classes tend to perform differently during different stock market phases and macroeconomic conditions. Therefore, an investor can reduce his portfolio risk since each asset class performance is not perfectly correlated with the performance of the other asset classes. The most characteristic example is the performance of stocks versus bonds. It is well known among investors and financial professionals that when stocks rise, fixed income securities (bonds) usually fall.
Diversification is critical if you want to protect your investment portfolio from rare events with disastrous consequences. Although it would be great to know for sure whether stocks or bonds will outperform over the next year, financial markets are very uncertain. The uncertain nature of financial markets is the reason why we should not put all the eggs in one basket.
An investment portfolio should not be concentrated to stocks. Despite the fact that until the end of the previous century stocks proved to be much more rewarding than bonds, there were many occasions when stock market performance was very disappointing. Moreover during the last decade stock investors have suffered dramatic changes in their wealth level because of the extremely volatile equity markets. Nowadays stocks do not seem to be so attractive as they used to be.
In addition, a stock portfolio is not appropriate for investors who seek an income stream with low volatility. A widow, for instance, having two million dollars to invest with no additional sources of income would optimally place a substantial portion of her wealth in fixed income securities which, under normal circumstance, can generate a steady flow of income. The widow’s main objective is not to increase her wealth, but to form a low risk portfolio with dividends and coupon payments which will enable her to meet her financial needs and preserve her lifestyle. On the contrary, a young entrepreneur in his late thirties, will probably be more interested in how to maximize his portfolio growth rate. A young individual with decent income has a long investment horizon and thus can afford more risky as well as more rewarding investments.
Asset allocation seems to be the principal determinant of both return and risk in investment portfolios. A number of researchers have concluded that the asset allocation decision accounts for the biggest part of portfolio performance, while other steps of the investment process such as market timing and stock picking account for a relatively small part. However, there is still much debate about the methodology and the result of these research papers. The main conclusion of this line of research is that an investor should make the asset allocation decisions in a cautious manner. A stock investor should base his asset allocation process on clear objectives, a proper investment horizon and realistic expectations about each asset class risk and return components.
StockTradingCollege.com, Stock Trading and Investing for Beginners