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Bullish
Bullish is the symbolic financial instrument of NOVA CAPITAL LIMITED, a company authorized by MISA BROKERAGE license, IBC / BROKERAGE company. For more information, see Overview below.
WHAT IS ASSET ALLOCATION?
As its name suggests, asset allocation is the collective percentage of investable capital ‘allocated’ to each ‘asset’ class. The conventional ‘60/40’ stock and bond portfolio showcases a traditional asset allocation model. Namely, 60% of investable capital is allocated to stocks while the remaining 40% of investable capital is allocated to bonds (see chart).
ASSET CLASSES
Traditional asset classes fall into two broad categories: equities (stocks) and non-equities (bonds and cash). Alternative investments represent a nontraditional category in modern portfolios. These broad asset classes consist of multiple ‘sub’ asset classes (see chart). For example, large-capitalization U.S. equities and international equities are sub asset classes within the broad equity asset class. U.S. Treasury notes and investment grade bonds are sub asset classes within the broad non-equity asset class. Managed futures and long/short strategies are sub asset classes within the broad alternative asset class.
THE IMPORTANCE OF ASSET ALLOCATION
Asset allocation is the most predominant component of portfolio performance. Studies have shown that asset allocation accounts for approximately 86% of portfolio returns.1 In short, the percentage of assets allocated to equities vs. non-equities is the principal determinant of portfolio performance over time.
RISK PREMIUM
Given that asset allocation determines a preponderance of portfolio returns, an investor may be tempted to allocate all of his assets to the asset class with the most upside potential. Generally speaking, asset classes with the greatest upside potential also have the greatest downside potential. Conversely, asset classes with the least upside potential also have the least downside potential. This is known as risk premium. Over time, an investor should be rewarded relative to the risk he assumes.
CORRELATION
Effective asset allocation can also insulate portfolio returns from excess volatility. This can be achieved by allocating capital with respect to the correlation of each asset to other assets within the portfolio. Correlation measures the degree to which assets move in the same or opposite directions. This measure ranges from +1 to -1. Assets which are positively correlated (+1) move in the same direction, while assets which are negatively correlated (-1) move in opposite directions. Assets which have no correlation (0) do not move in relation to each other (see charts). By allocating a percentage of capital to negatively or non-correlated assets, portfolio returns can be insulated from market volatility.
DIVERSIFICATION
The performance of different asset classes varies year to year. The best performing asset class in one year can easily be the worst performing asset class next year (see below). Past results are not indicative of future performance. The ability to consistently and reliably pick the best performing asset class each year has proven to be a nearly impossible task. A balanced, well-diversified portfolio has proven to be one of the best ways to capture consistent returns over time. A balanced portfolio offers exposure to the upside potential of multiple asset classes while attempting to limit downside risk (see chart below).
DETERMINING PROPER ALLOCATIONS
As previously indicated, the most crucial determinant of portfolio performance lies in the percentage of assets allocated to equities vs. non-equities. So how should an investor determine his allocations to each asset class? While equities may offer the best potential for growth over an extended period of time, their returns are often more volatile than bonds. However, while non-equities may offer the best potential for capital preservation, their returns often underperform equities over extended periods (see charts below).Therefore, a suitable asset allocation must be tailored to an investor’s individual time horizon, risk tolerance, and investment goals.
TIME HORIZON
While many factors can affect an investor’s ultimate asset allocation, his individual investment time horizon will have the most impact. An asset allocation suitable for a young professional at the start of his career is not necessarily suitable for an executive who is nearing retirement. Similarly, a foundation expected to exist in perpetuity may not have the same allocation needs as an operating fund covering an organization’s near-term expenses. For those who have long investment time horizons, higher allocations to equities may provide better potential for growth and wealth accumulation. Conversely, for those with shorter time horizons, higher allocations to non-equities may provide better potential for stability and wealth preservation.
Equally important to an investor’s asset allocation is risk tolerance. Assets with greater upside potential generally carry greater risk. While stocks generally outperform bonds over extended periods of time, they are generally much more volatile and carry a greater risk for loss. Conversely, while bonds generally underperform stocks over extended periods of time, they are generally much less volatile and carry less risk for loss. If an investor has a low tolerance for risk, a portfolio with a smaller percentage allocated towards stocks and a greater percentage allocated towards bonds may be more suitable. Conversely, a portfolio with a greater percentage allocated towards stocks and a smaller percentage allocated towards bonds may be more suitable for an investor with a high tolerance for risk.
RISK TOLERANCE
INVESTMENT GOALS
Finally, an investor’s asset allocation must align with investment goals. If an investor wishes to grow assets over a long period of time, a higher allocation to stocks may be suitable. On the other hand, if an investor merely wishes to preserve wealth and reduce risk for loss, a higher allocation to bonds may be suitable. An investor’s time horizon, risk tolerance, and investment goals are often synthesized in an investment policy statement. A financial advisor is suited and trained to assess the individual needs of an investor and tailor an asset allocation in order to help reach investment objectives.
Bullish-Leveraged Portfolio
OVERVIEW
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