Asset Allocation For Beginners

Asset allocation involves allocating portions of your investment fund into different asset classes. These classes include stocks, bonds, and cash equivalents like CDs and commercial paper.

If you’ve decided to invest in stocks (one big step for financial freedom), you’ll need to understand what asset allocation is and how it can help you.

As a human being, you’ve probably used asset allocation methodology once or twice, but now we’ll explore it on a deeper level.

Asset allocation involves allocating portions of your investment fund into different asset classes. These classes include stocks, bonds, and cash equivalents like CDs and commercial paper. You allocate your funds in any combination of these assets in fixed proportions/percentages and then balance out them out periodically.

As simple as this definition is, deciding what combination of assets to invest in and in what proportion can be a bit complex, but it ultimately depends on your investment goals.

How it Works

Imagine a man named John wants to invest ₦100,000 in a retirement fund. John is 26 years old and does not plan on retiring until he is 60 years. This means John is not in a hurry.

Imagine John is a daredevil, he isn’t scared to take on risk. His investment goals are to increase his fund so he can hopefully retire a millionaire.

After some reflective thinking and consulting professionals, John decides to invest 80 percent of his fund in stocks and 20 percent in bonds. That means ₦80,000 goes into stocks and ₦20,000 into bonds.

At this point, John’s asset allocation is 80 percent stocks and 20 percent bonds.

Let’s say after the first year, John’s stocks make a 10 percent gain but his bonds make only a 4 percent gain, without inflation. At this point, John’s stocks are worth ₦88,000, and his bonds are worth ₦20,800. His total investment portfolio is now worth ₦108,800.

If you do the math, you’ll find that John’s stock allocation is now 80.8 percent of his total fund, and his bond allocation is now 19.1 percent. Remember that John’s original allocation was 80 percent stock and 20 percent bond.

If John sticks with this allocation, then he would need to sell about ₦870 worth of stocks and use it to buy bonds. As time goes on, John may decide to reduce the percentage of stocks in his portfolio and increase the percentage of bonds. Let’s say he decides to invest 50 percent in stocks and 50 percent in bonds.

If his portfolio is 80 percent stocks, he would have to sell 30 percent and raise his bonds to 50 percent. These changes are based on his investment goals, market conditions, and risk tolerance. And that is a basic example of how asset allocation works.

Factors that affect your asset allocation strategy

Investment goals

Your investment goals determine how you apportion your funds. These goals involve how much you want to make and for what purpose. It could be growing your retirement fund, investing for a down payment on a house, or paying for a new car. Your investment goals are purely personal.

Time horizon

This is classified into short-term and long-term. The time allotted to investment also affects the level of risk an investor is willing to undertake. Take John, for example. He is 26 years old and is investing in his retirement fund.

He has about 34 years on his side and can invest in assets with higher risk, like stocks, because even if the value crashes in the short term, 34 years is enough time for the market to recover.

However, if his investment goals are short-term (typically under five years), then he may want to focus more on bonds that provide fixed, regular payments.

Risk Tolerance

Asset allocation is also determined by how much risk an investor is willing to undertake. If you don’t mind losing all your money, you can invest in high-risk, high-reward assets. However, if you have a low tolerance for losing money, you’ll want to stick to more stable assets.

Now that you understand the basics of asset allocation, you can start picking out assets you’d like to invest in. Once you’re done with that, move to types of asset allocation strategies.