In its simplest terms, asset allocation is the practice of dividing resources among different categories such as stocks, bonds, mutual funds, investment partnerships, real estate, cash equivalents and private equity. The theory is that the investor can lessen risk because each asset class has a different correlation to the others; when stocks rise, for example, bonds often fall. At a time when the stock market begins to fall, real estate may begin generating above average returns.
The amount of an investor’s total portfolio placed into each class is determined by an asset allocation model. These models are designed to reflect the personal goals and risk tolerance of the investor. Furthermore, individual asset classes can be sub-divided into sectors (for example, if the asset allocation model calls for 40% of the total portfolio to be invested in stocks, the portfolio manager may recommend different allocations within the field of stocks, such as recommending a certain percentage in large-cap, mid-cap, banking, manufacturing, etc.)
Asset Allocation Model Determined by NeedAlthough decades of history have conclusively proved it is more profitable to be an owner of corporate America (viz., stocks), rather than a lender to it (viz., bonds), there are times when equities are unattractive compared to other asset classes (think late-1999 when stock prices had risen so high the earnings yields were almost non-existent) or they do not fit with the particular goals or needs of the portfolio owner. A widow, for example, with one million dollars to invest and no other source of income is going to want to place a significant portion of her wealth in fixed income obligations that will generate a steady source of retirement income for the remainder of her life. Her need is not necessarily to increase her net worth, but preserve what she has while living on the proceeds. A young corporate employee just out of college, however, is going to be most interested in building wealth. He can afford to ignore market fluctuations because he doesn’t depend upon his investments to meet day to day living expenses. A portfolio heavily concentrated in stocks, under reasonable market conditions, is the best option for this type of investor.
Asset Allocation Models
Most asset allocation models fall somewhere between four objectives: preservation of capital, income, balanced, or growth.
Model 1 - Preservation of Capital
Asset allocation models designed for preservation of capital are largely for those who expect to use their cash within the next twelve months and do not wish to risk losing even a small percentage of principal value for the possibility of capital gains. Investors that plan on paying for college, purchasing a house or acquiring a business are examples of those that would seek this type of allocation model. Cash and cash equivalents such as money markets, treasuries and commercial paper often compose upwards of eighty-percent of these portfolios. The biggest danger is that the return earned may not keep pace with inflation, eroding purchasing power in real terms.
Model 2 – Income
Portfolios that are designed to generate income for their owners often consist of investment-grade, fixed income obligations of large, profitable corporations, real estate (most often in the form of Real Estate Investment Trusts, or REITs), treasury notes, and, to a lesser extent, shares of blue chip companies with long histories of continuous dividend payments. The typical income-oriented investor is one that is nearing retirement. Another example would be a young widow with small children receiving a lump-sum settlement from her husband’s life insurance policy and cannot risk losing the principal; although growth would be nice, the need for cash in hand for living expenses is of primary importance.
Model 3 – Balanced
Halfway between the income and growth asset allocation models is a compromise known as the balanced portfolio. For most people, the balanced portfolio is the best option not for financial reasons, but for emotional. Portfolios based on this model attempt to strike a compromise between long-term growth and current income. The ideal result is a mix of assets that generates cash as well as appreciates over time with smaller fluctuations in quoted principal value than the all-growth portfolio. Balanced portfolios tend to divide assets between medium-term investment-grade fixed income obligations and shares of common stocks in leading corporations, many of which may pay cash dividends. Real estate holdings via REITs are often a component as well. For the most part, a balanced portfolio is always vested (meaning very little is held in cash or cash equivalents unless the portfolio manager is absolutely convinced there are no attractive opportunities demonstrating an acceptable level of risk.)