Asset Allocation as a Risk Management Strategy

Every investor is in pursuit of their own “white whale”—that is, the perfect stock that’ll pave the way to financial independence for their children and grandchildren. After all, that’s the dream, isn’t it? Getting in on “lotto ticket” stock that would guarantee you could live the rest of your life in comfort without ever having to work again.

But the fact is—like winning lotto tickets—those stocks are are few and far between. And they’re usually loaded with enormous risk. Not to mention, the research can be arduous and timestaking. It involves combing through financial records and poring over company reports.

Investors who are ruled by this model are not only spending valuable hours, they’re leaving money on the table, and opening themselves to higher potential losses in the process.

In fact, studies show that the selection of specific assets in your portfolio only accounts for about 4% of its overall performance… reallocation due to anticipated market changes accounts for 2%... and the remaining 94% is attributed to asset allocation.

What is asset allocation?

Asset allocation is a foundational component to any investment strategy. It involves deciding how much of your portfolio you’re going to devote to different asset classes. Traditionally, these fall into three primary categories: equities (stocks), fixed income, and cash / cash equivalents. Most remaining types of investments (commodities, collectibles, property, etc.) fall under alternative investments.

The asset allocation strategy is rooted “Modern Portfolio Theory”—the concept that the markets are already efficient. The idea is that the best way to minimize risk and maximize returns is to lean into this efficiency, rather than trying to bet against it. Since asset allocation generally means diversification across multiple sectors and investment types, they’re less likely to be strongly correlated—which helps protect your portfolio in case of market or sector downturns.

Having a set strategy also helps to remove the emotion behind investing and reduces reactionary buying and selling.

How to create an asset allocation strategy

Asset allocation looks different in practice for every investor. It will depend on your individual risk tolerance and investment goals. It’s important to consider your short- and long-term goals (supplement your salary, buy a house, your children’s education, retirement, etc.), as well as how long you plan to be invested (your time horizon), how aggressive you want to be, and how hands-on an investor you are.

For instance, let’s say that you have $20,000 to invest and you have a time horizon of five years. Your asset allocation might be $10,000 (50% of your portfolio) in stocks (divided further among small and large caps, domestic, international and emerging markets, etc.), $8,000 (40% of your portfolio) in a mix of government and high-yield bonds, and $2,000 (10%) in cash equivalents. That would create a fairly risk-controlled portfolio without giving up too much growth potential.

But if you had a longer time horizon or have more taste for risk, you could potentially afford to be a little more aggressive and perhaps allocate 60–70% of your portfolio to stocks (which are more volatile and tend to represent longer-term investments, but also provide higher returns).

Again, determining which assets to add to your portfolio will be based on your specific investor profile. Equities tend to be viewed as the riskiest—but the most potentially lucrative—asset class, while cash equivalents are viewed as the least risky, but have substantially less upside.

Using asset allocation to control risk

There are several approaches to asset allocation. Some of the most common are:

• Strategic: This involves staying invested in a predetermined set of asset classes over the long-term based on their rate of risk and return. The idea is to ignore short-term fluctuations in market conditions. This resembles buy-and-hold investing.
• Constant-Weighting: This is similar to strategic asset allocation, but involves constant rebalancing based on market movements. If the asset declines in value, you buy more. If it increases in value, you sell. Think value investing.
• Tactical: This adds flexibility to your strategic asset allocation. It allows you to change course from your usual strategy to take advantage of short-term trades based on market conditions.
• Dynamic: This strategy follows the health of the market. It involves selling assets that aren’t performing well and buying more of the ones that are.
• Insured: This strategy involves setting a value below which your portfolio will not drop. If it remains above this value, you’re free to buy, hold or sell. But if conditions cause your portfolio to drop below this value, assets are reallocated to lower-risk investments.
• Integrated: This strategy involves components of all the ones above—although constant-weighting and dynamic asset allocation should not be used simultaneously since they’re based on competing theories.

One of the simplest and safest ways to diversify among asset classes is to invest in various mutual funds that follow them. There are also a number of online calculators that can help you determine the best asset allocation based on your goals and risk tolerance.

Rebalancing a portfolio

Rebalancing is an important component of any asset allocation strategy. Rebalancing simply involves taking a look at your holdings from time to time and selling and buying in order to get your portfolio back in line with your long-term asset allocation plan. In strategic and constant-weighted asset allocation, this is usually done on a predetermined timeline to bring the balance back to your original asset allocation.

For instance, let’s say you used strategic asset allocation and had 60% of your portfolio invested in stocks and 40% in bonds. Maybe the stock market suffered over this time and reduced your total holdings in that asset class to 45%. At some point, you would want to sell some profits out of your bond holdings and reallocate those funds back to stocks in order to bring yourself back to your strategic plan.

There’s no rule about when or how often to do this. But many investors will rebalance if an asset class moves 5% in either direction. That way you can manage your portfolio risk no matter what the broader market is doing.