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Asset allocation strategies explained

Asset allocation strategies are an essential part of building investment funds. That’s why at CMC Markets, we have a wide range of instruments to tailor your asset allocation. In this article, we explain how it can improve your trading strategy and diversify risk.

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What is asset allocation?

Asset allocation is the product mix that an investor or trader chooses to occupy their portfolio. It could include stocks, bonds, ETFs, currencies, commodities or share baskets, to name a few financial markets​​. Each of these — or only one, or a few — could be held in different qualities to achieve a desired return or objective.

Read on to learn different types of asset allocation strategies and how to determine the right asset allocation for you, based on factors such as your age, risk tolerance, time horizon and goals.

Why is asset allocation important?

Asset allocation can help people reach their financial and retirement goals and can help retired people manage their assets more effectively through their non-working years.

Asset allocation is also sometimes referred to as portfolio diversification​​. Diversification is the attempt to limit unsystematic risk. Unsystematic risk is the risk associated with a certain investment or individual stocks, such as a company going bankrupt and its stock plummeting.

With diversification — where an investor or trader holds a wide range of financial products in their portfolio — systematic risk is largely nullified because each holding has a small impact on the overall performance of the portfolio. The portfolio is only left with systematic risk, which is the risk of price fluctuations inherent to a group of assets.

We offer over more than 12,000 financial products to help traders to diversify their portfolios and achieve an asset allocation strategy that works for them.

What factors will affect my asset allocation?

Each person is different. Here are several factors that will affect how asset allocation can be approached:

  • Age. While each person is also affected by the other factors, older people tend to want more stable investments in order to preserve the capital that they have accumulated over their lifetime. Younger people may be more willing to take on more risk in order to grow their capital more rapidly.
  • Time horizon. Like age, time horizons (the number of weeks, months or years until a portfolio is needed for income) also plays a role. The longer the time horizon, the more risk can be taken if desired. Someone with a short time horizon — for example, a person approaching retirement — may no longer wish to take on high risk, as they could lose what they have accumulated right before they need to access that money.
  • Investment goals. Some people are ambitious in wanting to accumulate as much capital as possible, while others have more modest goals. What our goals are, such as how much we want to accumulate and invest, will affect how we choose to allocate capital.
  • Risk appetite. Some people can sleep at night knowing their money is held in riskier investments, while others cannot. Risk takers may make more money, but they also stand to lose more. Meanwhile, people with lower risk tolerances may end up with lower, but perhaps more certain, returns due to conservative investments. Neither approach is wrong; it’s down to personal preference and finding the right balance and asset allocation based on risk profile. Read more about money and risk-management​​.
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What are the different asset allocation strategies?

Here are several investment strategies that may help you balance all these factors to find your desired mix of assets. Each one has a different asset allocation theory, using stocks, bonds, cash, and other assets to create a personalised portfolio based on the above factors.

Strategic asset allocation

This allocation model uses historical investment returns to attain a desired return based on the product mix selected. For example, if an investor wants to attain 10% per year on average, and stocks have returned 10% on average, then the investor would need to be fully invested in stocks to expect that return.

If stocks return 10% and bonds return 6%, and they invest 50% of funds in each, then the investor could expect an 8% return. These allocations can be played with to fine tune the likely average yearly return.

Tactical asset allocation

Tactical asset allocation is similar to strategic asset allocation, but with more flexibility. Investors or traders choose their asset mix, as above, but can deviate from it to take advantage of opportunities as they arise.

For example, if stocks have tumbled and there are good deals present, they may choose to put more capital in stocks to take advantage of the expected recovery.

Age-based asset allocation

This portfolio approach is based on creating a stock and bond asset mix based on the investor’s age. The general rule is to take 100, and then minus the person’s age. That is how much they have in equities and the rest in bonds.

For example, for someone who is 20, they would have 80% in equities (100-20) and 20% in bonds. For someone who is 60, they would have 40% in equities and 60% in bonds. If someone reaches 100 years of age or older, their portfolio would be entirely bonds.

Life-cycle funds asset allocation

This asset allocation model provides capital at set times in future when an investor may need it, such as in retirement. The portfolio starts out with a bond and stock mix, but over time the portfolio becomes more weighted in bonds.

Bonds are bought that will mature when capital is needed. For example, the company provides the investor with cash for the matured bonds. This way, the portfolio automatically creates cash when it is needed, without having to sell anything.

Constant-weighting asset allocation

Constant-weighting asset allocation is a method that attempts to keep the original asset mix (in terms of percentages of the portfolio) constant over time.

For example, if stocks compose 50% of the portfolio, the investor keeps that ratio by rebalancing when needed. If stocks become 60% of the portfolio, the investor sells shares and buys other assets, which brings the ratios back to the appropriate proportion.

Dynamic asset allocation

This strategy is almost the opposite of constant-weighting. Investors or traders following the dynamic method can buy more of what is working and sell what isn’t. The investor needs to define rules for when they will buy or sell, possibly in percentage increments.

For example, if their stock holdings fall 10%, they may sell a chunk of their stock holdings, selling more if stocks fall another 10%. As stocks start to rise, they start accumulating stocks again. This is done with each asset in the portfolio, and thus requires active management of the portfolio.

Integrated asset allocation

Integrated asset allocation can be like strategic or tactical. The main difference is that while the prior two focus on returns, an integrated asset allocation approach also looks at risk tolerance to establish the ideal mix of assets.

For example, an investor may choose a tactical or strategic approach, but then also include an insurance model (discussed below) to make sure their account doesn’t drop below a pre-determined level. This way, they get the upside, but also control the overall risk to their net worth.

Insured asset allocation

With this method, an investor is allowed to trade and invest as they desire, but at a chosen level, they will stop trading and the funds are invested in low-risk assets, such as treasuries​​. This protects a base level of capital from being put at risk.

For example, an investor may have $1m. They want to try to grow it, but at the same time don’t want the account to drop below $900,000. They set a rule that if the account value hits $900,000, they exit all positions and buy treasuries with the proceeds. They can then decide how they want to proceed, or they can stay invested in treasuries (or whatever asset was pre-selected).

70/30 asset allocation

This method places 70% of funds into stocks and 30% into bonds. Bonds tend to move less than stocks, so the bonds help reduce the volatility and downside movement in the portfolio. At the same time, they don’t tend to produce as big profits, so performance is reduced slightly from what a 100% stock portfolio would yield. The 70% allocated to stocks are invested index funds, index ETFs or shared baskets. Read more about bonds vs stocks​​.

100% stock allocation

This allocation method is focused on the highest return possible, since there is no asset mix. The investor is concentrated in stocks, which over a long period of time produce higher returns than bonds and treasuries.

For example, an investor willing to be concentrated 100% in equities may also be willing to allocate some funds to share baskets, ETFs or other high-yielding assets. Since most stocks move together, there is little in this approach to protect downside.

The investor could also implement the insurance method, or a dynamic method, where they buy more stock as things are working, and sell and move into cash when they aren’t.

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What is the portfolio allocation rule of five?

The rule of five refers to not having more than 5% of the total portfolio invested in a single asset. For example, the rule discourages investing 10% of the portfolio funds into a single stock, or into a single bond.

Rather, the rule encourages placing a small percentage of funds into many stocks, bonds, and other assets, such as precious metals (the rule encourages diversification), currencies, interest bearing investments (such as money market funds), ETFs and/or share baskets​​.

Even if an investor decided to only invest in bonds or stocks, they could still follow the allocation rule of five by buying many different bonds or stocks instead of being concentrated in only one or a few.

What is the core satellite portfolio approach?

A core satellite portfolio has a big chunk of assets in one or a few core positions, such as diversified index funds or index ETFs. The rest of the funds in the portfolio are allocated to actively managed funds, exchange-traded funds​ or share baskets that could make a higher return than the core index funds. Remaining funds could also be used for short-term trading​ or invested in other assets like precious metals, bonds or currencies.

This approach keeps most of the account in index funds, which have low costs but average returns. The actively managed portion is likely to have slightly higher management fees, but the returns could be above average. Thus, ideally, the overall portfolio has a chance to do slightly better than average, but it could end up doing worse if the actively managed funds don’t perform better than the index funds.

When should I rebalance my portfolio?

People may rebalance their portfolio​ when the optimal portfolio allocation is no longer present. For example, the account has 5% of funds invested in 20 different assets. Over time, asset prices rise and fall, resulting in some assets having a larger percentage and others a smaller percentage.

You could rebalance to bring the amounts in each asset to back to optimal levels. This may mean selling a portion of some assets and buying more of others. This could be done at a set time, such as monthly, quarterly or yearly, or it could be done when the optimal portfolio is off by more than a certain percent, such as 5%. For example, if you are only supposed to have 5% in an asset, but it now accounts for 11% of the account, this approach would say it is time to rebalance.

How can asset allocation models help me?

Asset allocation models provide a variety of ways to reach investment goals, all while considering risk tolerance, age and time horizon, which are major factors in determining which asset allocation model to use. If risk concerns you, you could focus on low-risk allocation models. If you are more of a risk taker, or have a long-term horizon, you could focus on asset allocation models with higher return potential.

How should I factor in asset allocation correlation?

Some assets move in the same direction at the same time, which means that they are positively correlated. When assets move in the same direction, it can increase risk and make diversification difficult. Owning a selection of positively correlated assets means they all rise and fall together. While this can signal large returns if they all go up, it can also mean large losses if they all fall at the same time.

Some investors choose to put some uncorrelated assets in their portfolio. These assets don’t move in the same fashion as the other assets in the portfolio. Precious metals and stocks are an example. While they may occasionally move in the same direction, a stock index fund typically does its own thing and so do precious metals. Having both means more diversification in the portfolio, as it reduces the number of positively correlated assets.

Implement your asset allocation strategy with our exclusive products

We offer our clients access to more than 12,000 trading instruments, including stocks from around the globe, ETFs, treasuries, currencies, index funds, commodities and futures contracts, as well as custom built share baskets that are designed around themes.

Forex indexes​​ provide exposure to a selected base currency, such as the USD or GBP. How the index performs is based on how the currency performs against other currencies. Currency indices provide a diversification benefit since they may not be correlated with stocks.

We have more than 15 themed share baskets, including a basket of 5G stocks and a driverless cars basket. Multiple themed baskets can also provide a diversification benefit. In addition, in collaboration with RRG Research, our RRG Momentum+ share baskets​​​ are based on Relative Rotational Graphs and invest in stocks that are seeing an upswing in momentum.

Such products, along with an assortment of ETFs, treasuries, commodities and currencies, could be used to create a portfolio tailored to your needs.

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Why is asset allocation important?

Asset allocation helps investors to achieve financial goals while also taking into account their risk tolerance and time horizon. Asset allocation finds an efficient way to make all that saving and investing worthwhile in the future. Learn more effective trading strategies​.

What is the best asset allocation strategy?

There is no defined ‘best’ allocation strategy; this will vary because each person is different. Some people are risk-adverse, while others are risk takers. Some have long time horizons, while others have short time horizons. Taking these factors into consideration, look at the asset allocation strategies discussed to find a model that appeals to you.

Will diversification protect me completely?

When investing, there are always risks, so portfolio diversification won’t protect you completely. Any asset can drop in price, even stable company stocks or index funds. Diversification helps spread out capital so a drop in a single asset doesn’t cause too much loss, but if multiple assets drop at the same time, losses may not be completely mitigated. Therefore, having some uncorrelated assets in the portfolio may be helpful, since they won’t necessarily fall when other assets are. Learn more about portfolio diversification​.

When should I rebalance my asset allocation?

You should set yourself rules for when how often you will rebalance your portfolio. This could be at a certain time of the year, or it could be when your portfolio is no longer aligned with the asset allocation parameters you want.

Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.