Understanding Asset Allocation Versus Risk Allocation
With current market instability, inflation, and rising interest rates, more people are becoming acutely aware of the risks of investing. Financial markets are commonly known for their up-and-down nature, also known as market risk.
Some people go into the market with higher expectations than others, but those expectations often come with an equal amount of risk. Others have a lower tolerance for risk and are more comfortable with the possibility of lower returns. But, regardless of risk tolerance, a portfolio that’s ill-prepared to cope with volatility may experience some long-term consequences.
Back to Asset Allocation Basics
For many investors, asset allocation is their preferred investment strategy for focusing on long-term investing and striving for a balance between mitigating risk and returns over time. This strategy is centered around choosing a mix of asset classes based on your profile, investment goals, risk tolerance, and timeline.
The belief is that, by choosing a mix of assets, the assets will counter-balance each other in hopes that the portfolio doesn’t tip too far in one direction. Asset diversified portfolios often have a mix of asset classes, like stocks, bonds, precious metals, real estate, and more - all with varying levels of correlation to each other.
However, it is important to understand the difference between asset class and risk class when diversifying your portfolio.
Risk Class Versus Asset Class
One mistake that many investors make is diversifying by asset class, but disregarding risk class. It is possible to hold many different assets that are all subject to stock market risk. Therefore, if markets decline, all of your assets may be impacted even though you have a "diversified" portfolio.
Therefore, it is important to consider risk class as well as asset class for a well-diversified plan. For example, most fixed products such as CDs, annuities, and cash value life insurance are generally protected from stock market risk (depending on the specific product features), so they can help provide protection for some of your assets during market volatility, allowing you to ride out times of turbulence without subjecting your entire portfolio to losses.
Allocating for Risk
All investments are susceptible to risk, whether it’s market risk, inflation risk, interest rate risk, taxation, or liquidity risk. A comprehensive asset allocation strategy is as much about allocating risks as it is about allocating assets, and has the potential to mitigate the portfolio’s risk by offsetting the performance of various asset and risk classes. A properly allocated portfolio containing both fixed and market-based products should be more stable during times of change and uncertainty because different portions of the portfolio may respond more favorably in certain conditions.
Remember that portfolios can often require ongoing adjustments, also known as rebalancing. Different parts of your portfolio may under or outperform expectations and may become unbalanced based on the original assumptions the allocation was based on. The only certainty about the market is that it’s uncertain, so it’s important to review your investment strategy with a financial professional regularly so your portfolio stays aligned with your needs and goals.
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This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2023 Advisor Websites.