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Most people enjoy a roller coaster ride now and then, unless it involves their investment. Even though history has shown that the stock market always trends upward, more than a hundred billion dollars of investor cash fled the stock market crash in October of 2008, after it had declined by 40%. That cash didn’t return to the market until January of 2010 after the market had recovered it losses and rose to new heights. Those investors, many of whom had more than 80% of their assets invested in the stock market, will never truly recoup the losses they incurred over that two year period. If, instead, their portfolios, were allocate among several different asset classes “ bonds, metals, cash, real estate, and stocks in multiple market segments “ the variable the variable rates of volatility and the uncorrelated movements of each could have had the effect of stabilizing the overall portfolio.
What exactly is Asset Allocation?
Asset allocation is the process of selecting a mix of asset classes that closely matches an investor’s financial profile in terms of their investment preferences and tolerance for risk. It’s based on the premise that the different asset classes have varying cycles of performance, and that by investing in multiple classes, the overall investment returns will be more stable and less susceptible to adverse movements in any one class. All investments involve some sort of risk, whether it’s market risk, interest risk, inflation risk liquidity risk, tax risk. An individualized asset allocation strategy seeks to mitigate the risks of any one asset class though diversification and balance.
Your Individual Strategy
When done properly, your allocation of assets will reflect your desired goals, priorities, investment preferences and your own tolerance for risk. Asset allocation is an individualized strategy, so there really is no perfect mix of assets. Your individual strategy is built on a careful consideration of the key elements of your financial profile:
- Investment Objectives: What is it you hope to achieve using your investment dollars “ improve current lifestyle; achieve capital growth; fund a specific goal, such as a college education or a secure retirement?
- Risk Tolerance: This reflects your personal comfort level with market fluctuations that can potentially result in losses. Your understanding of inflation risk and interest rate risk are also important considerations.
- Investment Preferences: You may prefer one type of asset class over another based on a certain bias or interest towards that the characteristics of that class. Some people just prefer stocks over bonds or gold over real estate. That’s okay, but you should know how it impacts the balance of your allocation.
- Time Horizon: The length of time you are willing to commit to achieving your objectives. Certain asset classes are more suited for long term objectives while some are inappropriate for short-term objectives.
- Taxation: Investing in a mix of asset classes will have varying tax consequences. It is important to seek optimum tax efficiency in your over all asset mix.
Your Evolving Strategy
A sound asset allocation strategy includes periodic reviews. About the only certainty when it comes to the financial markets is that they will change, and so will your financial situation. Through market gains and losses, a portfolio can become unbalanced and it may be important to make adjustments to it to keep it in line with your investment profile. As people move through life’s stages their needs, preferences, priorities and risk tolerance change and so too must their asset allocation strategy.