Definition of Asset Allocation
Asset allocation divides your investments into assets such as stocks, bonds, and cash. The decision to allocate assets is a personal one. Your best allocation changes over time, depending on how much time you invest and your risk tolerance.
Types of Asset Allocation
Each asset class has different levels of risk and profit. The following are the three most common asset classes, from least risky to most risky:
- Cash: This is the least risky asset allocation. However, the return can turn negative once you’ve taken out the cost of inflation. This category includes money market funds and certificates of deposit.
- Bonds: Even if there are many types of bonds, they all fall into the category of fixed-income investments. For example, U.S. Treasury bonds are 100% guaranteed by the federal government. Moreover, they offer a little higher return than cash, so they are the safest bonds. However, bonds are not Shariah-Compliant investments.
- Stocks: Stocks are riskier than bonds because you could lose 100% of your investment. Stocks provide the best long-term returns and typically perform well during inflation. Stocks fall into three categories based on value: small-cap, mid-cap, and large-cap.
Why Is Asset Allocation Important?
The proper asset allocation maximizes your returns based on your risk tolerance. This means it assists you in obtaining the highest possible payoff for the amount of money you are willing to risk in the market.
- Highest Return
Many people make sporadic investments. Some investors make investments based on their level of aggressiveness or conservatism, which prevents them from realizing adequate returns. You can calculate the return you can expect from your investments based on the investment risks you are taking with the aid of proper asset allocation.
- Reduces Risk
The risks and rewards of each asset class are different, but diversifying your investments reduces volatility. The distribution of portfolio risk across asset classes is ensured by asset allocation. For instance, investing in debt and equity assets will shield your portfolio from the effects of a decline in any particular asset.
- Asset Allocation Maintains Discipline
It ensures you don’t invest too much or too little in any industry. It promotes self-control and helps achieve financial security.
- Stable Profits
You can get stable returns over time by properly allocating your assets. For instance, you want to invest your $5000 in savings over four years. You can divide this investment into various classes following the recommendations of your financial advisor. You can achieve balance by combining various assets.
Due to the volatility, markets are always vulnerable to rapid drops or sudden highs. Your investment portfolio will be better positioned to help you deal with market dynamics if you use the proper asset allocation strategy. It will guarantee that you make progress toward your financial goal every day.
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