When you created your investment strategy, your asset allocation reflected your goals, time horizon and tolerance for volatility.
Over time, however, any of these three factors, or others, may have changed, and your portfolio may need adjustments to reflect your new investing priorities. You may also need to re-evaluate the effectiveness of your risk mitigation strategy and employ a more strategic diversification tactic.
Diversification
The saying “don’t put all your eggs in one basket” has some application to investing. Over time, certain asset classes, or sub asset classes, may perform better than others. If your assets are mostly held in one kind of investment, you could find yourself under a bit of pressure if that asset class experiences volatility.
Keep in mind, however, that diversification is an approach to help manage volatility risk. It does not eliminate the risk of loss if an investment or set of investments sees a decline in price.
Asset allocation strategies are also used in portfolio management. When financial professionals ask you questions about your goals, time horizon, and tolerance for volatility, they are getting a better idea of what asset classes, or mix of asset classes, may be appropriate for your situation. However, like diversification, asset allocation is an approach to help manage volatility risk. It does not eliminate the risk of loss if an investment, or set of investments, sees a decline in price.
Determining an Appropriate Mix
Appropriate asset allocation is determined by each individual’s situation. Here are four broad factors to consider:
Time
Investors with longer time horizons may be comfortable with investments that offer higher potential returns but also carry a higher volatility risk, i.e. stocks. A longer time horizon may allow individuals to ride out the market’s ups and downs. An investor with a shorter time horizon may need to consider market volatility when evaluating various investment choices and the appropriate mix of asset classes.
Goals
They come in all shapes and sizes, and some are long-term, while others have a shorter time horizon. Knowing your investing goals can help you keep on target.
Tolerance for Volatility
An investor with higher tolerance for volatility may be more willing to accept greater market shifts and shocks in the pursuit of potential returns. An investor with a lower volatility tolerance may be willing to forgo some potential return in favor of investments that attempt to limit price swings.
Cash Flows
When investing in highly volatile asset classes, the greatest threat to long term returns is selling the investments at the wrong time. If you require a high level of cash flow from your investments you may not have a choice but to sell them at the wrong time. Determining the right mix of assets to support your needed cash flow is a very valuable exercise.
Strategic Diversification
Not all diversification is created equal and choosing “different” asset classes alone may not be giving you the risk mitigation you think. Your investment mix should be deployed using vehicles that have low or negative correlations while maintaining a positive return profile, this is a core tenet of Modern Portfolio Theory. Believe it or not, some bonds and commodities have a very positive correlation to equities even though they are completely different asset classes. Put more simply, if assets have a high correlation their respective prices are likely to rise and fall together rather than zig when the other zags. Just owning a lot of different “stuff” does not maximize diversification nor minimize risk. This is where a good portfolio manager earns their money.
Have Your Investing Priorities Changed?
If so, this is all the more reason to review and possibly adjust the investment mix in your portfolio. Asset allocation is a critical building block of investment portfolio creation. Having a strong knowledge of the concept along with an deep understanding of strategic diversification may help you when considering which investments are appropriate for your long-term strategy.
If you would like some assistance in assessing your portfolio risk please feel free to reach out, we are always happy to help and we perform complimentary portfolio analysis for people every day, just ask!
