In order to maximize returns, investors have a lot of variables that they need to take into account. How they distribute their assets can be the key to their success.
A common saying in investment circles is, “do not put all your eggs in one basket”. That statement is fundamental to the success of every investor. You would not want to put all your eggs in one basket because you do not want to expose them to danger all at the same time. So, you spread your assets across many baskets in the hope that if all does not go well with one or two baskets, you can maintain financial balance from the rest of the baskets. You are simply trying to manage your risks while securing your investment portfolio.
Investment, in layman’s terms, is using the money one already has to make more money. This is the pathway to achieving financial freedom. Every investment has some level of risk associated with it. So if you dream of attaining financial freedom, you must be willing to take some risks. Risks cannot be eliminated completely, however, there are measures you can take to limit your investment’s exposure to them. This is where Asset Allocation and Diversification are critically important.
What Is An Asset?
An asset, by simple definition, is any item that has economic value. Looking at the definition, we can see that many items can be regarded as assets. Some of the categories of assets are stocks, cash, real estate, bonds and crypto-assets (crypto is now considered an asset because it has all the characteristics of one).
Asset Allocation Defined
Asset allocation refers to how investors spread out their investments across different categories of assets. If an investor has, say, $50,000, how much of it will they invest in stocks, real estate, or crypto? The ratio of the spread and what categories of assets to invest in is a matter of choice, but it is often determined by the level of risk one is willing to take.
Why Do You Need To Allocate Assets As An Investor?
The values of different categories of assets respond differently to the same market condition. Since you do not have direct control over the market, it makes little sense to put all your money into one particular category. If you concentrate your investment in one category, you expose yourself to the most significant risk. You could lose a massive chunk of your investment if the market goes against you.
The smartest thing to do is to reduce your risk by carefully selecting asset categories that have different market dynamics. In that way, if one market is struggling, returns from others would hopefully balance out any losses incurred.
An example of an asset allocation strategy is,
Stocks – 30%
Bonds – 40%
Crypto – 15%
Cash – 15%
Diversification of assets is a strategy used to fine-tune the minimisation of risk in investment. After assets have been allocated to different categories of assets, diversification looks at the types of assets in each category and spreads the investment across them.
The crypto category of assets, for example, has Bitcoin and several altcoins such as Ethereum, litecoin, Stellar (XLM), and Doge among others. Careful analysis of their market trends over the years may show that there are cryptocurrencies whose values go up when that of Bitcoin is on an upward trend and vice versa. Spreading the allocation for crypto across cryptocurrencies that do not react the same way to BTC will minimise the risk in that category.
Another example is Stocks. Many companies operate in diverse industries. So, to properly diversify your investment, you can spread your investment in the stocks of companies in different unrelated industries rather than concentrating on companies in the same or similar industry.
Challenges With Asset Allocation And Diversification
While allocation and diversification are time-tested strategies that help investors manage their investments, many people do not find it easy to either plan it properly or implement it faithfully.
The first issue most people have is being able to read the markets and pick out the categories of assets to allocate or diversify into. A lot of people have biases that influence their choices. For such people, a professional investment adviser may be very helpful.
On the other hand, having the discipline to stick to the plan throughout the timeline (short term, medium term, or long term) is often difficult for people. If the market of a particular category is doing very well, people may be tempted to liquidate assets from other categories and switch over to the one going through a bull run. The temptation to make very fast gains is often the bait that lures investors into risks that may not play out well.
As an investor, money is a resource that must be managed appropriately for it to bring in the expected returns. Risks cannot be totally avoided while investing, but there are ways to reduce them while ensuring that returns can still be made from one’s investment portfolio.
Asset allocation and diversification are interrelated strategies that have been proven to be invaluable in helping investors minimise risks. If properly planned and faithfully executed, they will help one to achieve one’s investment goals.
Source : bsc.news