Asset Allocation: The Key to Long-Term Investment Returns

Watching the roller coaster ride of the stock market can make many investors queasy.  Even though the stock market has, historically, always trended up, investors can’t help but feel uneasy as they watch the values of their portfolios rise and fall with the market. That is, unless they also have a portion of their money in the bond market and the precious metals market, and in short term savings.  When portfolios are limited to one type of asset, its value will reflect the volatility of that asset class. But, when portfolios are allocated among several different asset classes, the variable rates of volatility and the uncorrelated movements of each can have the effect of stabilizing the overall portfolio.

Asset allocation is a strategy involving the selection of a variety of asset classes to create a diversified and balanced portfolio to match your specific investment objective and risk tolerance. The principal behind it is that all asset classes don’t move in concert, rather, they move in different directions at different times, influenced by different aspects of the economic cycles. 

For example, stocks prices tend to go up, when bond prices go down.  Gold prices will increase as inflation expectations rise, and while some types of stocks will react favorable, other s don’t perform well when inflation strikes. No one can predict when price movements will change, so the best course is to have some exposure to multiple asset classes.

Asset allocation can reduce the overall volatility of a portfolio and reduce market risk. But, investors also need to be aware of other types of investment risk that can impact their portfolio. Portfolios that aren’t protected against the risk of inflation, or interest rate risk, or tax risk can see their values adversely affected over a period of time.  A well-balanced and properly diversified allocation of assets can address all of these risks.

Your Asset Allocation Strategy

Your own asset allocation strategy should reflect your personal investment objectives and your risk tolerance.  There is no perfect mix of investments, except what works for you.  When developing your asset allocation, you need to consider these key factors:

Investment Objectives:  Are you seeking capital appreciation or income from your investments?

Risk Tolerance: Are you willing to lose any portion of your investment in return for a larger gain? If you invested $1000 and only received back $500, would that hurt your financially? What are your attitudes about inflation and the direction of interest rates?

Investment Preferences:  Do you prefer one type of investment over another? Is there a particular type of investment you want to avoid?

Time Horizon: How long are you able to commit to your investment strategy?

Keeping it Current

Things change over time. Certainly your financial situation will evolve and your attitudes and outlook will change. Investors tend to become more conservative with their money as they approach retirement.  And, the financial markets will change as will the economic outlook.  Your asset allocation strategy needs to change to reflect your evolving situation and the prevailing conditions of the markets.

Additionally, your portfolio allocation will change as a result of market gains and losses which can have the effect of changing its balance. For instance, if it experience big gains in the stock market are reinvested into more stock investments, your portfolio weighting might begin to tilt to heavily to stocks over the other asset classes.  Periodic reviews are necessary in order to rebalance your portfolio.