Portfolio Planning Strategy : Asset Allocation and Security Selection

Asset Allocation

It is commonly understood that different types of assets react to market conditions in different ways. For example, when stocks outperform the market, bonds tend to underperform. Similarly, when large-cap stocks beat the market, small-cap stocks may underperform.

These assets are not connected in terms of investment. Asset allocation is the process of combining non-correlating assets in order to achieve the best risk-return balance depending on an investor's investment profile. Asset allocation is done to reduce portfolio risk while optimizing returns in order to create a profitable portfolio.

The asset allocation is weighted more toward equities than bonds for an investor seeking higher returns yet willing to take on more risk. An aggressive allocation might be an 80/20 or 90/10 mix of shares and bonds. The asset allocation can be further separated among aggressive growth stocks, emerging markets, small-cap, mid-cap, and large-cap stocks within the equity section of the portfolio. A more conservative investor would invest in equities and bonds in a 60/40 or 50/50 ratio, with a higher allocation to large-cap stocks.

Asset allocation presupposes that asset prices will fluctuate in the future and that, depending on market and economic conditions at any particular time, certain assets may gain in value while others will drop. Asset allocation is more about risk and volatility management than performance management. Individual security selection presupposes knowledge of the future and that the investor has some information about the price direction in the future.