Building a successful investment portfolio involves many different decisions, the first and foremost of which is choosing an asset allocation. But what exactly is asset allocation, and why is it so important for investors?
What is asset allocation?
The asset allocation of an investment portfolio refers to the broad categories — or asset classes — that an individual is invested in.
The most common are stocks and bonds, but other assets like real estate and commodities are sometimes included. Often, these broad asset classes are subdivided even further, such as between foreign and domestic stocks or investment-grade and high-yield bonds.
All in all, there are numerous ways to classify an investment portfolio. However, a top-down approach, starting with the broadest categories and working down to more granular levels, is the best way to invest.
By starting with the broadest classifications first, you can identify and manage the largest risks to your portfolio.
Let’s take the example of a common stock versus a corporate bond. Both are tied to the same economic risk: the business activity of a company.
Bondholders receive fixed, contractual payments with a defined return of capital at maturity. Stockholders receive variable payments, if any, in the form of a dividend and are not guaranteed any return of capital.
In addition, if the company fails, bondholders are paid first while stockholders get only what is left over. Clearly, these two asset types come with very different risks even within the same company.
Properly segmenting these risks is critical in constructing an investment portfolio that meets your needs.
Why is asset allocation important?
One of the key tenets of sound portfolio management is understanding not just how individual investments behave on their own, but also how they interact with one another.
Beginning the investment process with broad asset allocation ensures that you are diversifying risks properly. For example, diversifying between broad asset types like stocks and bonds will lead to much greater risk reduction than simply diversifying between the stocks of different companies.
You should certainly do both, but focusing on broad asset allocation will lead to the biggest diversification gains.
Finally, focusing on asset allocation helps investors properly evaluate how new investments fit their portfolios.
New investments are constantly presenting themselves, and it’s easy to get lost in the excitement of a new opportunity; however, adding investments without considering the big picture frequently can leave you with overlapping and unnecessary risks.
Like a bad pot of soup, many investors sprinkle in the flavors of the day, leading their finished portfolios to be less than desirable.
On the other hand, focusing on asset allocation can help you avoid investments that you already have exposure to, as well as seek out more complementary opportunities for your portfolio.
Finding the proper asset allocation is one of the first steps in building a successful investment portfolio. If you have questions or want help with your asset allocation, our experienced team of professional investors would be happy to chat; just send us a note!
