The Importance of Asset Allocation in Managing Investment Risk

Risk and return are two fundamental concepts of investing. Typically, investments that provide high returns on a long term horizon incur higher risks because they fluctuate more over short term investments. However, on average, long term returns are higher than short term.

Investors today have greater access to different types of investments. By mixing different classes of assets, investors diversify their portfolios to leverage risk and portfolio volatility through the selection of mix of assets that are expected to react differently under different market conditions. Asset allocation is a key factor that can help achieving and retaining a well-diversified portfolio.

Defining Asset Allocation

Asset allocation is an investment strategy that allows leveraging investment risk by allocating it among different classes of assets, including equities (stocks and stock funds), fixed income (bonds and bond funds) and cash (certificates of deposit, money market funds and T-Bills). Because different classes of assets have different levels of risk and react differently to market fluctuations, asset allocation is a powerful tool to anticipate market changing conditions and increase a portfolio's return.

Asset allocation is typically expressed in ranges, thus allowing the investment manager the freedom to invest toward the upper or the lower end of the ranges. For instance, if the investment policy requires that common stocks be 50 to 70 percent of the portfolio value, bonds should be 20 to 40 percent and cash should be 10 to 30 percent, the investment manager should allocate the different investment classes based on the profile of the investor. If the investor is aggressive, the investment manager will increase the allocation of stocks toward the 70 percent upper end of the equity range and decrease bonds and cash toward the 20 percent and 10 percent lower end of the bond and the cash range respectively. If the investor is conservative, the investment manager will increase the allocation of bonds toward the 40 percent upper range and decrease equity and cash toward the 50 percent and 10 percent lower end of the equity and cash range respectively.

Factors to Consider When Setting Up an Asset Allocation Plan

To set up the proper asset allocation plan, investment managers consider an investor's wealth, investment horizon, risk tolerance and return objectives. These factors identify an investor as investing on short term or long term, conservative or aggressive, looking for growth or income and so on.

In particular:

a) Investment horizon

Investment horizon is very important in determining the proper asset allocation to leverage risk. For instance, investors with long term investment horizon require less liquid and higher risk investment portfolio because they have more time available to leverage risk and anticipate potential losses.

If the investment horizon is 25 years to 30 years, it is more suitable to choose a dynamic portfolio. Higher allocation in more aggressive asset mixes like equities is expected to provide higher returns on a long term horizon. Besides, aggressive portfolios typically outperform inflation on a long term investment horizon. Therefore, it makes sense for an investor who invests long term to set up a portfolio that does not involve conservative choices.

Instead, for an investor who invests short term, a conservative portfolio is more appropriate. Higher allocation in more conservative asset mixes like bonds and money market funds is more likely to preserve the invested money. However, stocks should not be totally excluded so that the portfolio still incurs growth.

b) Risk Tolerance

Investors are typically risk-averse. This means that are not willing to undertake a higher risk, unless they anticipate a higher return on investment. Similar to investment horizon, the investor's risk-return profile is very important in determining the asset allocation plan.

Conservative investors have specific spending goals and are not willing to undertake a higher risk on their portfolio. Therefore, the proper asset allocation for a conservative investor would be fixed income.

Instead, aggressive investors are willing to invest additional funds and undertake a higher risk on their portfolio because they believe they are more likely to be provided with a higher return on investment. Therefore, the proper asset allocation for an aggressive investor would be equities.

c) Return Objectives

Return objectives are related both to investment horizon and risk tolerance. Investors who aim at high return are more likely to undertake a higher risk on a long term horizon in order to have more time to leverage the risk and anticipate potential losses. Investors who are satisfied with an average return on investment are more likely to invest short term, undertaking the least possible risk.

Why Asset Allocation Is Important

Asset allocation is extremely important in retaining a well-diversified portfolio. The effects of asset allocation on investment performance have been thoroughly examined by several studies. The studies are based on the performance of bond funds and mutual funds for a period of 20 years and have concluded in majority that 90% of a fund's returns are subject to its target allocation plan.

A proper asset allocation plan can help reduce investment risk because through diversification portfolio risk is spread on different classes of assets. In doing so, the growth opportunity is not limited to particular securities, but can take advantage of the opportunities derived by a mix of securities that react differently under different market conditions.

Also, asset allocation can help reduce portfolio volatility. By investing in a mix of securities across different asset classes, investors can create a well-diversified portfolio. Losses from securities that underperform under specific market conditions can be offset by gains from securities that overperform under different market conditions. On average, a well-diversified portfolio can provide a higher growth opportunity will less volatility.

In conclusion, asset allocation is a very important decision in investing. Across all funds, asset allocation explains the 90% of the fund's returns over time. This means that prudent investors can enjoy higher returns on long term by establishing the proper asset allocation strategy that suits their wealth, investment horizon, risk tolerance and return objectives. A well-diversified portfolio can go a long way toward ensuring higher return on investment on long term rather than short term.

Sources:

Brinson, G. P, Singer, B. D., Beebower, G. L., (1991), Determinants of Portfolio Performance II: An Update, Financial Analysts Journal 47, no 3: 40-48

Ibbotson, R. G., Kaplan, P. D., (2000), Does Asset Allocation Policy Explain 40, 90 Or 100 Percent Of Performance? Financial Analysts Journal 56, no 1: 26-33

Reilly, F. K., Norton, E. A., (2006), Investments, Seventh Edition, Thomson ONE Higher Education