Why is asset allocation important?

Asset allocation helps investors to achieve their financial goals by defining a time horizon and managing their risk. Allocation is a key concept for investors who want to maximize their chances of success on the market.

May 12, 2022
Economics and Finance

Allocation or diversification?

Allocation and diversification are two different but complementary concepts. Allocation is expressed as a percentage and considers the notion of risk within the portfolio. Diversification consists in investing your capital in different investment sectors and in different regions. The diversification of your portfolio will not be achieved without the implementation of a good allocation strategy.

Allocation is about asking the question: “How will I implement this diversification?”. Allocation depends on different factors and can change over time due to, for example, market behavior, socio-economic conditions, personal needs,… Allocation must always make sense and must respect a certain balance. If an allocation takes up too much space in your portfolio, it is recommended to reallocate in order to always aim for a balanced portfolio. For example, if your crypto allocation becomes too heavy, you can reallocate part of the portfolio into a stablecoin, or if your equity portfolio becomes too large, it is possible to rebalance the portfolio by allocating part of the equity to a less volatile allocation like precious metals or defensive funds.

Allocation and its reasoning

Allocation depends on a series of factors, often independent of the investor's will. Therefore, it is important to develop a strategy linked to your allocation by following some key elements:

- Determine the possibilities: depending on your means, the notion of feasibility can quickly become relative as an investor. The question to ask yourself is “What can I save today?”.

- Determine the criteria of your allocation: consider the time scale (short term, medium term and long term) and the diversification of your portfolio (asset classes, location, equity or real estate).

- Respect your available liquidity: whatever the asset allocation strategy, there is a golden rule: available liquidity must always correspond to at least 10% of total assets.

- Determine the risk/return ratio and the liquidity of your investments: the notion of risk/return depends on the time factor, the asset class and the liquidity that a given investment represents.

The above table shows us that when risk/return is high, the remaining liquidity is reduced. This can, for example, be the case for a short-term cryptocurrency trader's portfolio. On the other hand, when the risk/return is low, the available liquidity is higher. For example, the case of a long-term investor in low volatile assets such as precious metals (gold or silver).

Market sentiment and tracking

Market sentiment and tracking are also two important elements for an optimal portfolio allocation. Applying market sentiment to a trading or investment strategy allows a better control of the portfolio. A good trader will normally be able to assess whether the market is becoming increasingly overvalued or undervalued. Also, it is very complicated for an investor to keep track of all the assets invested, their entry price, the average price or all the profits or losses made or not. Tracking allows you to make better decisions regarding your allocations.

Conclusion

Asset allocation is an essential principle in portfolio management. It allows to build a portfolio adapted to the investor's profile. Asset allocation gives you a clear vision of one's investments and to measure the risks as well as the benefits of an allocation, it also allows the portfolio to compensate the loss of an allocation by another allocation.

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