What is asset allocation? How can it impact your investment portfolio?

Author: Maria Smith

Source: MapleMoney

Your asset allocation can have a significant impact on your investment portfolio. But what is asset allocation? And how can you best take advantage of it within your portfolio? Read on to find out everything you need to know to get the most out of your asset allocation to accelerate the achievement of your financial goals.

What is asset allocation?

Asset allocation is an investment strategy. It involves investing in assets that align with your goals, time frame to invest, and risk tolerance. Essentially your asset allocation is the mix of assets within your investment portfolio. These assets are typically equities, fixed income, and cash equivalents.

By having a blend of assets within your portfolio, you can smooth out the ups and downs of the market. Each type of asset will have its own risk and reward. And all assets typically do not move up and down at the same time based on the same factors.

Asset allocation is one way of diversifying your portfolio among various asset classes.

Factors that affect your asset allocation decision

Three main factors will affect your asset allocation decision. These factors are the type of asset, the time frame you have to invest, and your risk tolerance.

Type of asset

There are 3 main types of assets (or asset categories) considered with general asset allocations. But there are also other asset classes such as real estate, collectible art, and vintage vehicles. Each type of asset has its characteristics and risk/reward.

Cash equivalents

Cash or cash equivalents such as money market securities and GICs (guaranteed investment certificates) have the lowest risk of any investment. But, they also have the lowest reward or return. If your investments are all cash equivalents, you could be losing spending power over time due to inflation.

In the long term, a portfolio made up solely of cash equivalents would have a negative return. Something that nobody is seeking.

But cash and cash equivalents are not all bad. They can be critical short-term investments if you need access to the funds within one year.

Fixed income (Bonds)

Bonds are known as fixed-income investments. They provide a higher return than cash (and therefore a bit more risk) but a lower return than equities. One benefit that bonds have over stocks is their capital preservation. But not all bonds are the same.

The risk of bonds can differ from government bonds (some of the safest bonds because federal, provincial, or municipal governments back them) to junk bonds (some of the riskiest bonds). Corporate bonds fall somewhere between the two, and their risk/reward will depend on the company's stability in offering the bond.

Bonds are suitable for shorter-term investments that are longer than one year but typically less than 5 years.

Equities (Stocks)

Equities or stocks are the riskiest of the three asset classes, but they also offer the potential for the highest reward and return.

Like bonds, there are different types of equities that you can invest in.

One way to decrease the risk of investing in equities is to invest in broad-based index funds. These equities own a portion of numerous companies, so your return is not solely based on one company.

Because of the volatile nature of equities, they are better investments for the long term of time frames greater than 5 years.

Time frame to invest

The stock market tends to trend up over time. But in the short term, the stock market can be very volatile with multiple ups and downs.

The longer the time frame you have to invest, the more it makes sense to invest in equities because your investment will have time to rebound when the market eventually goes up. This doesn't mean that you should solely invest in equities, but you can be more tilted toward them if you are younger and investing in a retirement account such as your RRSP.

The shorter time frame you have to invest, meaning you need that money in 5 years or less, the more your portfolio may favour fixed income or cash equivalent assets. That way, if the market does drop right before you need to withdraw the money, you are more likely to retain your capital.

These are just general guidelines, but typically the longer your money has to grow, the more risk you can take with your investments. As your withdrawal date approaches, you may consider moving your assets into fixed income or cash equivalents to help protect your principal.

Risk tolerance

As you can see from above, each asset class comes with its own risk/reward. There are also levels of risk within each asset class.

Typically the greater the risk is with an asset, the greater its potential for a reward or more significant return. But high-risk investments aren't all sunshine and roses. There is also the risk that you could lose your investment entirely. A portfolio invested only in one company is at stake if that company goes bankrupt.

Your risk tolerance has a relationship with the type of asset and time frame to invest. All three of these factors work together to help you determine your ideal asset allocation.

Asset allocation vs. Diversification

Diversification is having many different risk/return levels within your investment portfolio. And while asset allocation is one way to diversify your portfolio, it should not solely be depended upon as your diversification strategy.

A truly diversified portfolio would have a mix of asset classes and also a combination of each of those assets. For example, a well-diversified portfolio may include a mixture of government bonds and corporate bonds within their fixed income asset portion of their asset allocation.

Aligning your asset allocation to your goals

Aligning your asset allocation to your goals can have powerful results. An asset mix that fits with your goals can help you achieve them faster. But an asset allocation that doesn't align with your goals can delay or even sidetrack them.

When deciding on your asset allocation, here are a few things to remember.

What is the goal of your investment?

Are you saving and investing for retirement or a downpayment on a home? Both will require slightly different asset allocations to meet your goals.

Along with what your goal is, you also want to consider the time frame of your plan. Long-term goals can have asset mixes that are riskier than shorter-term goals. This is because the longer-term the goal is, the more time the market has to rebound from a dip. With a short-term goal, the last thing you want is for the market to drop right before you need your investment.

The closer you are to needing the money, the more you may want to favour fixed income within your asset allocation.

What stage of life are you in?

Are you currently in an accumulation or decumulation stage of life? If you are in your peak earning years, you may have a different asset allocation than if you are already retired.

In your peak earning years, you can afford to be a bit riskier because you have time (and the possibility of more contributions) for the market to recover or rebound.

But if you are already retired, you may want to be more conservative with your money because you may no longer be adding contributions. Life expectancy also plays a role here. Someone with 40 years of retirement ahead of them may invest differently than someone in the later stages of their life.

What is your risk tolerance?

What asset allocation will help you sleep at night? Only you can answer this question. And it is okay if your asset mix is not 100% optimized for everything.

The important thing is that you can sleep at night and stay invested in your plan. If seeing the market drop makes you want to sell everything, you may wish to update your asset allocation to be more conservative.

Why portfolio asset allocation matters

Some financial professionals believe that asset allocation is more important than the specific assets that you invest in. This is because your asset mix is an overarching strategy that affects more than a single asset.

Your asset allocation will smooth out the volatility of the stock market and can help to ensure that your money is there for you when you need it. The last thing anyone wants is for the value of their investments to drop just before they need to withdraw from it.

It is one part of a diversified portfolio, and if done right, your asset allocation will give you peace of mind and help you sleep at night.

Finally, if you align your asset allocation to your goals, it can help you achieve them sooner.

Asset allocation and target-date funds

An easy way to achieve asset allocation is to invest in target-date funds. These funds are structured to address the needs of investors and are a type of asset allocation fund. The longer the time frame, the more they may be invested in equities. And as the target date draws nearer, the fund rebalances to favour fixed income to help preserve capital.

Target date funds can be an all-in-one solution for asset allocation.

Looking for next steps?

If you are interested in a balanced solution, consider these target-date funds: Fidelity ClearPath(r) Portfolios as an option for adding asset allocation to your investments. Your advisor can help you figure out which Fidelity ClearPath(r) Portfolios are right for you.

Talk to your advisor about Fidelity ClearPath Portfolios →

If you are looking for an exchange-traded fund (ETF) option or are a self-directed investor, consider Fidelity All-in-One ETFs for your investment portfolio.

Fidelity All-in-One ETFs →

This article was written by Maria Smith from MapleMoney and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.