Posts Tagged ‘model’

It can be argued that asset allocation is the single-most important aspect to investment planning. But interestingly enough, too many people skim through the process of building the right asset allocation model for them. This should never be the case. Here are some of the biggest reasons why asset allocation is so important.

Market Timing Becomes Irrelevant. The most basic premise to financial planning is establishing, well, a plan. This plan can be summed up as financial goals (e.g. “I need $2 million”, time goals “I need it in 15 years,” and risk goals “I need to survive the stress of investing between now and then”) that translate into asset allocation. For example, large investment goals with modest savings will result in the need for greater growth components compared to fixed income. With asset allocation on your side, you will no longer worry about the individual weightings as you will stay the course. Timing entry and exit points is less relevant.

As well, sticking to an asset allocation plan will allow the investor to avoid buying in when markets are hot and bailing out of cooler markets when other asset classes seem more appealing. This is particularly true after the last few years; while many people might have wanted to bail out of the market in March 2009, they would have missed out on the exponential gains since. The right asset allocation model deters people from making such decisions as market timing is no longer a factor.

Exposure Limits Determine Trading Decisions. By incorporating the right asset allocation model, you essentially put together a mission statement for your investment portfolio. While some Fund of Funds portfolios will automatically rebalance your portfolio for you, other investments will require some effort on your part to ensure that you are never more exposed to any given asset class. This is particularly important during times of high market volatility. When markets rise by a certain acceptable factor (some will use 10% as a guide while others will rebalance based on time such as daily, weekly, quarterly, etc.) then it could be time to rebalance. For example, 2008 saw tremendous downward market volatility which left the fixed-income over-exposed and equities under-exposed. This meant that investors would trim their fixed income holdings to invest in equities. In the case of 2008, the balance was thrown off by dropping equity prices. Often, the case for rebalancing is made when equity prices increase exponentially during strong market booms.

Risk Tolerance. When building your asset allocation model, one of the greatest considerations will be risk tolerance. This is key because risk often dictates the type of investments people make. By following your model throughout your investment career, the risk factors are balanced within your portfolio, so certain investments that may be higher risk are offset by investments that are lower risk.

Again, the key to a successful investment program is asset allocation. We will look at this more closely in the asset allocation model section, which provides greater examples and illustrations for particular investor profiles.