HOW TO DETERMINE YOUR ASSET ALLOCATION
The major factors that determine the returns on your investment are asset allocation, security selection, market timing and many other factors. In Asset allocation, you have to decide among various investment types i.e. stocks, bonds, cash equivalents, etc. It is indeed a big decision and around 90% of your portfolio performance depends on the asset allocation.
While determining the asset allocation, you should have proper knowledge on the various investment types. For example, you should know that stocks provide the highest returns among other assets; however, in this investment, you need to bear the greatest risk too. Bonds, on the other hand, provide significantly less risk, but in this type, the return is comparatively less too. Cash equivalents, which is a very short-term investment is almost risk-free.
Instead of picking only one of the three investment types, you should split your investment among the three asset classes to best utilize them. You should make the allocation depending on your expected return and also the amount of risk you are planning to bear. Economists have developed various models, which can tell you how different balances among the asset classes affect your risks and returns. To know more about the splitting, you should ask for some investment advice from the experts.
While making the best investment decisions and optimizing your asset allocation, you will have to consider some of your personal factors too. This includes:
a) Your age
b) Health condition
c) How much you need from your portfolio
d) Changes in life events.
These factors are important in the sense that, depending on these factors, you can determine the level of risk that you will be able to bear.
There are many formulas to determine the proper asset allocation. The most common formula among these is the Rule of Thumb. According to this formula, subtract your age from 100. Whatever value you get should be the percentage of your portfolio that should be invested in stocks. In the other sense, as you grow older, you should increase your investment in bonds.
There are some certain drawbacks of the rule of thumb since it doesn’t consider your health and income level. Therefore, sometimes it may mislead you towards a wrong decision. However, this rule is far better than the investment advice from the brokers who advocate that major part of your investment should be in stocks and less than 10% in bonds.
To make the best investment decision, you will have to allocate your assets in any of the four portfolios mentioned below:
1. Low-risk level
2. Medium low-risk level
3. Medium-high-risk level
4. High-risk level
To determine the particular portfolio which will suit you the best, you need to study the historical records of each portfolio and make your judgment. However, the past result may not be reflected in the future environment. But, it will enable you to make some idea about the market movements.
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