12 Sep Understanding Asset Allocation
What Is Asset Allocation?
Asset allocation is an investment strategy used by many savvy investors. The investor builds his portfolio by investing in a range of asset classes; stocks, mutual funds, real estate investments, private equities, investment partnerships and cash equivalents based on his financial goals, investment duration and risk tolerance.
Each asset class is vulnerable to different risk during different stages of an economic cycle; therefore, by investing across several asset classes, the risk exposure of the investor can be lessened.
For example, if the stock market is booming, bond prices typically fall and when stock prices begin to fall, real estate prices are generally more attractive.
An asset allocation model guides the way the investor splits his overall portfolio over the various asset classes. However, the investor has the ability to decide on the details of each asset class. i.e. Within ‘stocks’ alone, the investor can decide to invest via ETFs or pick individual stocks.
How To Select An Asset Allocation Model That Suits You?
There are many asset allocation models available. Within BigFatPurse, Alvin has written about the Singapore Permanent Portfolio and has shared many other famous asset allocation models during our webinar, workshops and courses (Subscribe to our newsletter to get notified of the latest events).
With so many options, how should you go about choosing one?
As mentioned above, an investor should select a suitable asset allocation model based on his financial goals, available investment horizon and risk profile.
For example, a retiree who has one million dollars to invest and has no other income source should place a large portion of their wealth in assets that will provide a steady income with little risk of losing his retirement fund.
Whereas a young investor who wishes to build his wealth may choose to own a portfolio that containing more stocks if he is able to withstand market fluctuation.
What Are The Different Types of Asset Allocation Models?
There are four distinct objectives that an asset allocation model may fall into. They are growth, balanced, income and capital preservation. We explain each objective below:
The growth investment allocation model is suitable for those who have a source of income and want to build long-term wealth. The assets do not generate any income because the investor has a source of income and does not need it. The growth investor would usually inject funds into their portfolio regularly.
A growth portfolio usually outperforms other asset allocation models during a bull market; however, they tend to draw down the most during a bear market.
This asset allocation model falls between growth and income. It allows the investor to be able grow their wealth, while minimizing the stress of extreme fluctuations.
This model attempts to strike a balance between income and long-term growth. It tends to contain a mix of asset classes that experience capital gains and generate cash. This allows the portfolio to grow over time, albeit slower than the growth models.
This investment strategy typically includes bonds, dividend paying stocks from large, profitable corporations and REITs (real estate investment trusts).
The Singapore Permanent Portfolio is a relatively balanced asset allocation model.
Income generating portfolios typically consist of investments in real estate (typically REITs), treasury notes, blue chip stocks that have a history of dividend payments. This investment strategy is typically used by those who are nearing retirement.
This model is designed to preserve the investor’s capital. Investors who require higher liquidity (within the next 12 months) and do not wish to risk their capital tend to go for these models.
The assets in this model generally contain approximately 80% in cash and cash equivalents, such as treasury bonds, short term bonds or money market securities.
The investor would have to accept the possibility of not producing a return on par with inflation.
Asset Allocation Models Are Not Permanent
Your financial needs and goals will change as you go through the different stages of life. Your ideal asset allocation model is expected to change.
Most guides would recommend switching to a different asset allocation strategy a few years before an major expected change. For example, an investor who is 10 years away from his retirement may begin moving 10 percent of his holding into an income-oriented model each year. By the time the investor retires, his entire portfolio would have evolved into an income portfolio.
The Devil is in the Details
Diversifying across various asset classes alone does not mean that your portfolio is immune to market changes. You have to make sure that each component representing the different asset classes are relatively less risky.
A good way to start a portfolio based on your ideal asset allocation model is to use ETFs that represent the different asset classes.