Having sound investment strategy behind the management of a retirement portfolio is as important as understanding the markets in which investments are made. One method of investment strategy is in asset allocation.
Asset allocation is an investment strategy that aims to balance risk and reward through the division and distribution of assets in a portfolio according to an investor’s goals, risk tolerance, and investment horizon. Though there are various types of asset allocation strategy, they all focus on having a diverse distribution of funds across different asset classes.
Various asset classes perform differently in response to market conditions. Asset allocation takes advantage of these variations in order to create a portfolio that minimizes risk for the desired return.
Based upon past patterns of asset risk and return, forecasts are run to determine the potential performance of assets. These are all based on the general assumption that future behavior will follow past trends. This does leave some risk to falling prey to the butterfly effect in which a small miscalculation or change in a forecast results in drastically incorrect long-term forecasts. However, this just highlights the necessity of re-evaluating portfolios every few years to match your current investment horizon and risk tolerances.
At its heart, asset allocation is highly personalized to the investor.
Allocation of assets for a risk averse investor will be very different than the allocation for a risk tolerant investor. There are some general principles that can be followed to help determine what are acceptable risk levels for an investor’s given goals and investment horizon. Allocating assets in a broad series of investments with varying levels of risk allows for a measure of balance that can fortify a portfolio against fluctuations in the market.
Investment companies will often offer a series of model portfolios to demonstrate various methods of allocation for the different asset classes and risk tolerances. Though these are ideal for demonstrating the general benefit of asset allocation based on an investor’s risk tolerance, investors should strongly consider a more personalized approach to their own asset allocation.