Asset allocation refers to the investor portfolio holdings’ distribution, by the type of asset, such as; stocks, mutual funds, ETFs. This asset distribution is often used by investors to diversify their portfolios in order to achieve risk/reward balance based on their investment strategies.
As an example, a 25-year-old will ordinarily have a different asset allocation than a 75-year-old retiree, owing to the fact that each investor uses their portfolio to achieve different goals. The 25-year-old may look to build their portfolio for the next 30 years and therefore will most likely have a higher risk tolerance than the 75-year old that depends on their life savings. An allocation strategy with a more risk tolerance may contain heavier weight towards stocks rather than bonds and cash.
When making the decision on how to allocate your assets within a portfolio, it is important that one understands the difference between systematic risk and unsystematic risk. Systematic risk is the risk inherent in the entire market or market segment. This risk is unpredictable and cannot be completely avoided, as it affects the overall market and therefore cannot be avoided by investing in a specific stock or industry. While systematic risk cannot be completely avoided through diversification, it can be mitigated through the act of hedging. For example, diversifying a portfolio between stocks and bonds can hedge one’s risk. A change in interest rates may increase the value of bonds and in turn, decrease the value of stocks. The act of hedging can reduce the systematic risk involved and equally minimize losses, in the event that a drastic change in stocks or bonds hits the market.
The systematic risk of a stock or fund can be measured by looking at the beta. A beta greater than 1 implies that the given stock or fund has a greater systematic risk than the market, while a beta less than 1 represents that the stock or fund holds a lesser systematic risk than the market. A beta equal to one indicates the stock or fund has the same systematic risk as to the market.
Unsystematic risk, unlike systematic risk, is a risk associated with a specific industry, sector, or stock and can be mitigated through diversification. Some examples of unsystematic risk include managing risk, location risk, and political and legal risk. One may increase their political and legal unsystematic risk by investing in biotech and pharmaceutical companies as the success of these companies highly depends on the approval of their pipeline products by the FDA and other government agencies. Legal and political unsystematic risk can be reduced by diversifying the portfolio and investing in fashion and technology companies along with biotech and pharmaceutical companies. While unsystematic risk can be minimized through diversification, the portfolio will continue to have systematic risk (market risk), which unavoidably affects all stocks if there is a market crash or recession.
When looking to invest, one can choose from a variety of financial tools in order to design a sound asset allocation strategy that meets one’s risk tolerance. ETFs, mutual funds, stocks, bonds, and cash are a few of many options that one can choose from when designing a diversified portfolio. It is important to understand asset allocation so that one can design an investment strategy that fits their needs, goals, and risk tolerance.