One of the biggest question marks for an investor with some money to spare is where and how should he invest. An investor can invest in different types of asset classes. The age-old adage of “don’t put all your eggs in one basket” comes to mind here. If we graduate this a bit further, it means that as an investor you must invest in different asset classes and diversify your portfolio of investment. You need to decide what proportion of which asset class you would like to keep in your portfolio. This is what will constitute your target asset allocation. Another aspect of asset allocation is to rebalance your assets in your portfolio as with the passage of time one particular asset class can accrue greater value than another; therefore, in order to bring it in line with the original asset allocation target, you may want to sell some of the higher valued asset to rebalance the weightings of the assets in your portfolio of investment.
We will now discuss how to allocate assets in your portfolio; how much of which asset to invest in. A certain percentage of your portfolio may consist of stocks, while another may have bonds; yet, another part may consist of real estate investments. You have to decide based on your financial situation, risk tolerance threshold, holding power, and how much of each asset class you would like to have in your portfolio. For example, stocks may constitute 70%, bonds may make 20% of your portfolio, and real estate investments may make up 10% of your portfolio.
Decades ago, there was the ‘Rule of 100’ which helped determine the ideal asset allocation in stocks, while the remaining investment was to be done in bonds. For example, if you were 40 years old, then, as per Rule of 100, you were to subtract 40 from 100, the resulting number 60 would indicate an investment of 60% in stocks while the remaining balance would indicate 40% investment be done in bonds. But with the returns in bonds being static or smaller and with people living longer in present day & age, it was found that the Rule of 100 was too conservative for most investors. Hence, many financial advisors now recommend that investors subtract their age from 110 to 120 to determine a suitable stocks-bonds asset allocation.
But the Rule of 100 might not be an all-encompassing rule. It does not factor in other asset classes such as real estate, mutual funds or ETFs etc. At the same time, it might not be the best way forward for you because if your risk tolerance level is low, then you might want to invest more in bonds than in stocks. However, if you have a normal or above average risk tolerance level, then you might want to invest as per the latter-day Rule of 100 to determine the stocks-bonds asset allocation for your portfolio. This will allow for a suitable investment vehicle for you as well as provide well for you by the time you retire.
Another aspect of discussion on asset allocation is diversification. Diversification can be done in many ways such as by Market Capitalisation, Dividend Yield or Yield (Bonds) etc. Market Capitalisation is the total number of shares of a company multiplied by the share price. The larger the Market Capitalisation, the bigger the company. Dividend Yield is the annual dividend per share divided by the stock’s price per share. The higher the Dividend Yield, the greater the payout given by a company. Yield is the annual return on a bond or debt instrument at that point in time. The higher the Yield, the greater the return from that debt instrument or bond. Based on your financial position, risk tolerance level, and holding power, you may decide on which stocks or bonds to invest in. If your risk tolerance level is low, you may want to invest in large cap companies, stocks with high dividend yield or bonds with high yields for a given period of time. If your holding power is also low, then you may want to invest in bonds with high yields and stocks with sufficient dividend yields to suit your financial situation and needs. It is these considerations which will help you decide the asset allocation of your suitability.
Apart from diversification, an aspect of asset allocation is maintenance of your target asset allocation through rebalancing of your portfolio. Suppose you have invested in stocks and bonds with a weightage of 60% stocks and 40% bonds over a period of ten years. It is possible that the stocks grow faster than the bonds over said time duration. In such a case, you may want to offload or sell some stocks and invest that money in bonds to rebalance your assets to the original proportion of your asset allocation (60%-40%).
On the other hand, if you want to reconfigure your asset allocation such that you now want to have different proportions of assets in your portfolio, then you may want to dispose-off more of the bonds or other asset classes and concentrate more on stocks or any other asset class. Basically it’s your call, your financial situation, your risk tolerance level and your holding power that should dictate the asset allocation at your desired levels.
These prime considerations of diversification and rebalancing based on your desired configuration of asset allocation will determine your satisfaction in terms of returns earned and risk profile maintained in keeping with your financial situation, risk/ return objectives, and holding power.