How does asset allocation deal with risks?

Asset allocation is the strategy of dividing an investment portfolio across various asset classes to maximize returns while minimizing risks. It is an organized and effective diversification method.

What are the asset classes that comprise asset allocation?
Investors’ options typically fall within three classes: stocks (equities), bonds and cash. But within these classes are subclasses or alternatives that can include the following:

• Large-cap stocks: Issued by large companies with a market capitalization generally greater than $10 billion
• Mid-cap stocks: Issued by mid-sized companies with a market cap generally between $2 billion and $10 billion
• Small-cap stocks: Represent smaller-sized companies with a market cap of less than $2 billion; tend to have the highest risk due to lower liquidity
• International securities: Issued by foreign companies and listed on a foreign exchange; allow investors to diversify outside their country but also have exposure to country risk (the risk that a country will not be able to honour its financial commitments)
• Emerging markets: Securities from the financial markets of a developing country; offer a higher potential return but have a higher risk, often due to political instability, country risk and lower liquidity
• Fixed-income securities: Composed of debt securities that pay the holder a set amount of interest, periodically or at maturity, as well as the return of the principal when the security matures; tend to have lower volatility than equities as well as lower risk because of the steady income they provide; include corporate and government bonds
• Money market securities: Debt securities that are extremely liquid investments with maturities of less than a year; Treasury bills (T-bills) make up the majority of this type of securities
• Real estate investment trusts (REITs): Trade similarly to equities, except that the underlying asset is a share of a pool of mortgages or properties, rather than ownership of a company

High-risk, high-return choices are better suited for investors who have a high risk tolerance, a longer time horizon to recover from losses, and larger sums to invest. It is this risk-return trade-off that makes asset allocation crucial. Since different asset classes have different risks and market fluctuations, proper asset allocation shields an investor’s entire portfolio from the ups and downs of a single asset class.

What is the role of model portfolios in asset allocation?
To make asset allocation easier for clients, many investment companies create model portfolios, each comprising different proportions of asset classes and satisfying a particular level of investor risk tolerance. Generally speaking, these model portfolios can be classified into the following categories:

Conservative Model Portfolio
A conservative portfolio allocates a large percent of the total portfolio to low-risk securities such as fixed-income and money market securities. Its main goal is to protect the principal value of an investor’s portfolio. As such, it is often referred to as “capital preservation portfolio.”

Moderately Conservative Model Portfolio
A moderately conservative portfolio is ideal for those who want to preserve a large portion of their portfolio’s total value but are willing to take on higher risk to get some inflation protection. A common strategy within this risk level is called “current income” wherein investors choose securities that pay a high level of dividends or coupon payments.

Moderately Aggressive Model Portfolio
A moderately aggressive portfolio, often referred to as a balanced portfolio, divides assets almost equally between fixed-income securities and equities to provide a balance between growth and income. This portfolio is best for investors with a time horizon of more than five years and a medium level of risk tolerance.

Aggressive Model Portfolio
An aggressive portfolio mainly consists of equities, so its value tends to fluctuate widely. The main goal of this portfolio is to obtain long-term growth of capital. As such, the strategy of this portfolio is often called a “capital growth” strategy. To provide some diversification, investors with this portfolio usually add some fixed-income securities.

Very Aggressive Model Portfolio
A very aggressive portfolio consists almost entirely of equities. Since this portfolio carries a considerable risk level, the value of the portfolio will vary widely in the short term.

Here are sample asset allocations using these model portfolios:

These proportions can, of course, be modified to suit investors’ individual needs. Once they have chosen their portfolio investment strategy, it is vital to conduct periodic portfolio reviews, as the value of various assets change. And if they want to reset their portfolio back to its original state, they would need to rebalance it. Rebalancing is the process of selling portions of an investor’s portfolio that have slightly declined or increased.