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What Is Asset Allocation? How It Works & Who Needs It

Brad Chastain Director of Education U.S. Money Reserve

Written by Brad Chastain

Jul 21, 2023

Asset allocation is an essential component of portfolio diversification that helps mitigate risk and protect wealth. But what all does asset allocation involve? Is it something an individual can manage on their own, or is a financial planner needed?

If you already have a portfolio or are putting together a financial plan and want to figure out the best asset mix for your unique financial situation and goals, you may wish to explore different asset allocation calculations and approaches. Exploring the options can help you find the approach that may make the most sense when rebalancing your portfolio.

Read on to get a better idea of how asset allocation works and how to make it work for you.

What Is Asset Allocation?

Asset allocation is a financial strategy that involves utilizing funds to acquire different types of assets to help make your portfolio more diverse. As Investor.gov notes, diversifying your portfolio may help reduce the risk of financial losses during market downturns or events that might negatively impact one or more asset classes.

The Connection Between Asset Allocation and Diversification

Asset allocation is an important part of any portfolio diversification strategy. It’s the final step that puts your asset decisions into action. The basic steps for portfolio diversification typically include:

  • First creating a financial plan that identifies both where your finances stand today and where you would like them to be in the future.
  • Next comes researching and selecting a mix of assets based on your financial planning and goals.
  • The last step is asset allocation—deciding how much of each asset to add to your portfolio based on your financial plan and available funds, then purchasing those assets.

Why Is Asset Allocation Important?

As the Motley Fool’s financial experts explain, there are many different asset classes, each with its own risks and potential rewards. Having the right allocation of assets in your portfolio can help provide maximum financial security over both the short term and long term.

The general idea is that choosing assets to balance a portfolio helps cushion the blow of market downturns. If performance dips for one type of asset in your portfolio, your other assets may hold steady or possibly improve, balancing out your risk exposure and helping protect against losses.

Popular Strategies for Asset Allocation

Asset allocation is very personal. It’s also highly dependent on your unique financial circumstances and goals for the future. You may wish to consider using several strategies when forming your overall asset allocation plan.

Asset Allocation by Goals

Financial goals are the driving force behind asset allocation. They provide direction not only for selecting which types of assets to include in your portfolio, but also for when to acquire and sell those assets in order to help you achieve your goals.

The U.S. Securities and Exchange Commission (SEC) beginner’s guide to asset allocation points out that both short-term and long-term goals can impact your portfolio diversification strategy and influence asset allocation. Paying off a property loan is an example of a short-term financial goal that could affect your overall asset mix. Doing so reduces debt and adds an asset in the form of mortgage-free real estate, but paying off that mortgage may also deplete cash reserves you might have used to acquire a different type of asset—one that may have realized a potentially greater return in the short or long term.

Financial goals can help you set the tone for your portfolio diversification strategy and serve as the foundation for financial planning. You may wish to speak with a financial professional to determine your best path to accomplish your goals and create a financial plan that allows for diverse asset allocation.

Asset Allocation by Time Horizon

How long do you have to reach your financial goals? Do you have a few years or a few decades on your time horizon? Time horizon refers to the number of months, years, or decades a person has allowed themselves to reach a financial goal. Generally speaking, those with a longer time horizon are more willing to allocate part of their portfolio to riskier assets.

If you have a fixed timeline in mind for how and when you will utilize your savings, that may be a useful starting place for figuring out which assets may be best for your portfolio.

Asset Allocation by Risk Tolerance

Risk can be another major factor in selecting assets for your portfolio. Each of us has a different level of risk tolerance, which may be influenced by our age, time horizon, and current market conditions. You may find that your risk tolerance changes over time, which may mean that you would need to be reexamine your asset allocation strategy as you age.

Typically, lower-risk assets are slower to appreciate and might not have as big returns compared to riskier assets. The trade-off is that these assets are also more likely to realize gains or hold in price. Lower-risk assets are also less likely to be dramatically impacted if market conditions change. Precious metals are one popular example of a lower-risk asset that may help provide a portfolio with more stability.

Asset Allocation by Age

As mentioned above, your age may come into play when selecting your asset allocation strategy because your age may affect your time horizon. It may also be fundamental in shaping your financial goals.

How old you are may also impact how your funds are allocated. It’s not uncommon for younger people to have student loan payments, need to purchase a vehicle, or want to save for a down payment on a home. Middle-aged people tend to be at the top of their earning potential and have fewer loans to pay off. Seniors may have no debt but be on fixed incomes that limit their asset allocation options.

When to Consider Rebalancing Your Asset Mix

As time passes, an asset may contribute more or less protection or growth potential to your portfolio. This may result in an imbalanced asset mix that no longer aligns with your financial goals or push your portfolio’s level of risk exposure out of your comfort zone.

Depending on the factors above and discussions you might have with a financial professional, you may determine that rebalancing your portfolio is the most effective way to improve your overall asset allocation. Rebalancing your portfolio means that you adjust your asset allocation strategy by buying and selling assets to create a new portfolio mix that may be better aligned with your financial situation or goals.

According to the U.S. Securities and Exchange Commission, a portfolio can be rebalanced in one of three ways:

  1. Purchasing assets in underrepresented categories to create more balance
  2. Selling assets in a category that’s overrepresented and using the funds to purchase assets in underrepresented categories
  3. Reallocating contributions so that more is contributed to underrepresented asset categories

It may be beneficial to discuss rebalancing your portfolio with a financial advisor because rebalancing may have tax repercussions or associated fees.

How Precious Metals Can Contribute to a Balanced Asset Allocation Strategy

When considering your asset allocation strategy, you have an opportunity to expand your portfolio and improve its level of diversification. During the initial phases of portfolio diversification when you are planning and setting goals, you may find that your asset allocation doesn’t have enough variety. Harvard Business School is one of many institutions that have determined alternative assets, such as precious metals like physical gold, may help provide more diversity in a portfolio, thus helping mitigate the potential effects of market condition changes.

Alternative assets like precious metals may serve as a counterweight to conventional paper-based assets like stocks and bonds. A precious metals IRA, for example, is a type of self-directed IRA that allows you to diversify your retirement portfolio with physical gold, silver, and other precious metals while enjoying the same tax benefits as other IRAs. Diversifying with a precious metals IRA may help reduce your overall risk exposure and provide long-term growth potential that is not directly connected to the financial markets the way stocks or bonds are. In general, self-directed IRAs may be great tools for those wishing to expand their asset allocation strategies because these accounts not only allow for physical precious metals, but also provide more flexibility and control than conventional IRAs.

To expand your knowledge of physical precious metals and how they can fit into your asset allocation strategy, request a free Precious Metals IRA Information Kit today.

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