Choosing the right investment strategy is the key to reaching your investment goals by reducing risk and generating more revenue. The first step is to understand the definition of asset allocation, a term that will help you choose the right strategy and generate better returns.
What is Asset Allocation?
Asset allocation is the strategy of classifying and dividing the portfolio, into asset classes. These asset classes can be stocks, commodities, currencies, bonds, and money market securities.
Most of the investments made by investors are in one of the four asset classes: cash, stocks, bonds, or real estate, and there are sub-classes under each class
- Large-cap stocks: Investopedia classifies stocks of companies that have a market capitalization more than $10 billion as large cap stocks.
- Mid-Cap stocks: Companies with market capitalization between $2 billion and $ 10 billion qualify as mid cap stocks.
- Small-cap stocks: Any company which has market capitalization of less than $2 billion is known as a small cap company.
- Fixed income securities: These are debt securities, which means that an issuer pays a fixed amount at the time of maturity and interest payments periodically. This is a low risk investment, but this doesn’t mean that it is a guaranteed return. A company can default- but the chances are low, compared to ups and downs of stock market. The return, however is also capped on the upside.
- Money market : These are instruments which typically have a maturity of less than 1 year. T-Bills (Treasury Bills) come under this sub class.
- Real Estate Investment Trusts (REITS): REITS trade like stocks, but the underlying assets are real estate properties which can be residential or commercial, depending upon the trust.
Maximizing Return & Minimizing Risk
Investors who are less willing to take risk and want more certainty should look at a bond portfolio. There is a risk-return trade off, because a higher risk means a potentially larger return. Your decision about risk and return comes down to your goals, time horizon, and your preferences about taking risk.
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Ideally, you should have a mix of asset classes to reduce your risk. If one of the asset classes declines in value, other classes may perform well.
Choosing the Right Strategy
Before, deciding on the right portfolio strategy, you need to define certain parameters that make it easier to design a portfolio. These are:
- Define your goal. You need to clarify your investment goals, which may be retirement planning, or purchasing a home.
- Time horizon is another critical thing to keep in mind while deciding on a portfolio. A time horizon of 10 years or 30 years is going to make all the difference while deciding on a strategy. A longer horizon allows you to take more risk, because you have more time to recover from any losses.
- Risk-taking ability is also a factor when choosing asset classes, and risk taking depends on your financial stability and time frame. If you have covered your financial needs adequately and the money will not pay for living expenses, you may be willing to take more risk. .
To make the asset allocation process easier, many asset management companies provide investment strategies, from a conservative to a very aggressive. Here are some of the common portfolio strategies:
This portfolio is suitable for someone who is looking to minimize risk. Investments in this portfolio will include fixed income securities and money market instruments. This is suitable for a retired individual looking for a fixed return, or a person who is just about to achieve his goal and doesn’t want to lose the return already earned.
In order to beat inflation, a small portion of this portfolio may be invested in blue chip (large) stocks. The idea with this kind of portfolio is not to generate great returns, but instead to preserve capital and generate a stable return that can beat inflation.
Moderately Conservative Portfolio
A moderately conservative strategy, means investing a majority of the assets in fixed income and some portion in equity. It is suitable for someone who is ready to take more risk to generate a moderate return. For example, if a person is nearing retirement, he might look to preserve his earnings while earning a higher return.
Balanced portfolios have an equal allocation between equity and debt.
Aggressive portfolios have a large amount invested in equities, and these portfolios have a high level of volatility. Depending upon your expectations, you can mix your portfolio between large cap, mid cap and small-cap stocks.
Review your Portfolio Periodically
Once you have chosen your portfolio investment strategy, it’s important to conduct periodic portfolio reviews, as the value of various assets will change. As you get closer to the end of your investment time horizon, you may shift assets from equities into fixed income securities to protect your principal from declines.
Consult with a financial advisor and a CPA for specific recommendations.
About the Author
Harneet Bahri is an engineer and MBA graduate. After having worked for banks and educating clients about basics of investing, he now works with SAMT AG which is an asset management company, and offers free portfolio advice to customers. You can email Harneet at: email@example.com.
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