Asset allocation theory is not everybody’s piece of cake, but it is a system worth considering before making decisions on how you will invest your money. Asset Allocation theory is an attempt to balance risk through the adjustment of percentages of different types of investment in a portfolio. This allocation of assets is determined by the investor’s goals, time frame and risk tolerance. It depends upon the classifying of assets to determine these balances. There have been many criticisms of such a planned and antiseptic approach to investing and gut instinct is seen as the polar opposite of this theory. The overall aim is to marry together the high rewards of high risk investments with the durability and dependency of low risk investments.
Determining the returns in an investment is crucial to building a portfolio. Naturally, the first element that needs to be organized is the goals and time frame along with the desire to be exposed to risk. Without knowing these basic elements it is impossible to determine an adequate asset allocation pattern.
Once decided, it is time to examine the asset classes that can be introduced to the portfolio. These include, at the most basic, cash and cash equivalents. These tend to sit in bank accounts and accrue low, but steady amounts of interest. Then there are fixed interest securities such as bonds, which can be governmental or corporate, high class or relative junk. Then there are also stocks, commodities, real estate, collectables, which may or may not accrue value, insurance products, derivatives, foreign currency investments and venture capital.
As can be seen from this list there are a number of different types of investment tools that can be used. Each one can be sub-allocated into high and low risk versions. For example, foreign currencies such as the Yen and US Dollar are seen as safe currencies for investment, but the same cannot be said of the Euro at the moment let alone the Russian Ruble. Bonds from Great Britain are far more secure than junk bonds from Spain. One last example would be comparing the stocks of Facebook and Apple. The latter is a stable company with continued growth and plenty of financial reserves, the former is a company that came in over priced and has depreciated in value quickly.
Naturally, the aim is to take the above classifications and organize them into some kind of strategy. Strategic Asset Allocation aims to develop the perfect balance between risk and return over the long-term. A Tactical Asset Allocation move, meanwhile, will look at expected gains in the market, assets with the potential to increase in value or companies about to explode big time and position the assets in those areas to reap a tactical victory. Core-Satellite Asset Allocation, on the other hand, combines the balance of strategy with the use of potential.
A fourth common strategy seen in Asset Allocation is Systematic Asset Allocation. This works when taking into account three assumptions. Firstly, that the markets will provide information about the available returns on an investment, that these expected returns are commonly expected by the group and that actual returns can be deduced from the study of expected returns and the consensus about them.
If investing in the United Kingdom or a number of other countries such as New Zealand, South Africa and Singapore, one possible consideration is the use of unit trusts. These are open-ended investments, which work toward a good balance between high and low risk investments. Asset Allocation can play a large part in the strategies of unit trusts.
Rebalancing Your Allocation
There is a commonly held theory that the more an investor checks the value of their stocks and makes changes to them, the less that person makes in profit. By the same token, a bad set of investments will only get worse over time except for an unexpected EU catastrophe of some kind. In this case, the asset allocations made require a re-balancing This means taking a fresh approach to the strategy being used, the classes of products in the portfolio, their balance and the specific investments made. The Securities and Exchange Commission in America recommends that this act of re-balancing is performed every six to 12 months.
Asset Allocation vs. Gut Instinct
There have been a number of criticisms of asset allocation theory. One of these is that the level of risk tolerance is not known prior to the creation of a portfolio of investments, but this can be overcome by talking with the investor prior to making the investments. Secondly, generalizing the risk factor into classes can be too broad and not reflect the reality.
One of the biggest criticisms has been the absence of gut instinct and hands on investments and the fact that asset allocation tries too hard to reduce risk without going for top end rewards. This is to say that Asset Allocation is a cold-hearted calculation that does not take the heart or the gut into account. For those who put great stock in gut reactions to investments, asset allocation will take that away.