Depending on how involved you are in finance, both personally and otherwise, “asset allocation” and “diversification” are likely two terms that you have heard of before. But what makes asset allocation so important? Why does it matter if your investment portfolio is diversified? Today, we’re going to break down those terms and exemplify how they matter in your personal finance goals.
What is asset allocation?
Asset Allocation and Classes Overview
Asset allocation is the strategy that investors use to divide their investment interests among different asset classes. Asset classes are traditionally cash and cash equivalents (money market funds, which have a maturity of less than one year), fixed income securities (bonds), and equities (stocks). Some other asset classes include futures, commodities, and real estate.
Assets are grouped into categories based on shared characteristics and reactions to market conditions. For example, when the economy is heating up, equities are usually doing well. Not every one of them, but as a group, they track closely with economic performance. Equities and stock broking firms are also subject to the same regulations by the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Real estate, a separate asset class, is regulated neither by the SEC nor FINRA.
The important thing to note is that each of the asset categories comes with a different risk, which is most often measured by the standard deviation. Although “risk” is commonly associated with something negative, the term in finance does not have a valenced connotation; it can be in the investor’s favor or not, and it just indicates how much a certain asset is likely to deviate from its historical return.
Risk varies between asset classes and within them. For the main asset classes, the risk ordered from most to least is as follows: equities, fixed income securities, cash and cash equivalents (money market funds). Within each of these categories, there is a risk range, too. A stock in a recent high-tech startup is likely riskier than a tried and true company like AT&T. A bond with a Moody’s C rating and an investment horizon of 20 years is riskier than one with a Aaa rating and a maturity of one year.
Diversification is a way of managing the risk both between and within asset classes, so that investors can receive returns that are in line with their risk tolerances. If you were to weight your portfolio heavily towards high-risk equities, your portfolio would be riskier than others based on both the asset class you have chosen and the types of stocks within that asset class. You cannot have high returns without high risk, but choosing this sort of strategy also means you would, statistically, experience the lowest of lows.
This is why having a mixture of risks is the recommended approach. By diversifying your portfolio with stocks, bonds, money market funds, and other asset classes, and then further diversifying with securities that track with and against the economy, you create a portfolio that is better protected against economic hardship.
With all of that said, you may be thinking that it is best to invest everything in low-risk bonds if you want a very safe portfolio or to invest everything in extremely-high risk stocks for a risky portfolio with out-of-this-world returns. However, both of these options are probably inefficient, meaning that you could be getting better returns for the level of risk you are taking on.
Portfolios that balance risk and return in the most optimal way are said to exist along the efficient frontier. Any portfolio that exists below the efficient frontier is taking on the same risk for a smaller return than those portfolios on the line.
The tangent line above the efficient frontier line in the graph below is the Capital Market Line, which is another way of modeling risk and return.
Strategic asset allocation ideally puts your portfolio close to the efficient frontier, based on your individual risk tolerance and goals. Since future returns cannot be known precisely, having a point exactly on the efficient frontier is theoretical, but using this theory and principles of diversification as tools is helpful in identifying where your portfolio may be inefficient.
For more information on personal finance, contact the certified financial planners at Morris Financial Concepts. We look forward to helping you reach your individual investment goals.
The opinions expressed herein are those of Morris Financial Concepts, Inc. (“MFC”) and are subject to change without notice. This material is for informational purposes only and should not be considered investment advice. Nothing contained herein is an offer to buy or sell a particular security. Past performance is not indicative of future results.MFC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about MFC including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request. MFC-19-23.