Portfolio and Asset allocation in personal finance

In personal finance, you begin to save and grow funds which are later invested in instruments either money market, capital market or debt instruments to further create wealth that will enable you meet your future need(s). This is where portfolio and asset allocation comes in.

 What ‘Portfolio’ means

Investopadea defines portfolio as a grouping of financial assets such as stocks, bonds and cash equivalents, as well as their funds counterparts, including mutual, exchange-traded and closed funds.

Portfolios are held directly by investors and/or managed by financial professionals. Prudence suggests that investors should construct an investment portfolio in accordance with risk tolerance and investing objectives.

Risk tolerance

Risk tolerance could simply be defined as the level of risk the investor or portfolio holder is able to tolerate. It is therefore, the degree of variability in investment returns that an investor is willing to withstand. … You should have a realistic understanding of your ability and willingness to stomach large swings in the value of his investments; if you take on too much risk, you might panic and sell at the wrong time.

Investment objective

Investment objective is the purpose the investor hopes to achieve from embarking on the investment. A conservative investor’s primary objective is to preserve the capital and receive regular income.

Such investors have a low tolerance for risk and hence a major chunk of their investment should be allocated to debt or money market mutual funds like income schemes amongst few others.

Investment portfolio

Investment portfolio is defined by Investopadea, as a pie that is divided into pieces of varying sizes, representing a variety of asset classes and/or types of investments to accomplish an appropriate risk-return portfolio allocation. Many different types of securities can be used to build a diversified portfolio, but stocks, bonds and cash are generally considered a portfolio’s core building blocks. Other potential asset classes include, but aren’t limited to, real estate, gold and currency.

 Impact of risk tolerance on portfolio allocations

While a financial advisor can develop a generic portfolio model for an individual, an investor’s risk tolerance should have a significant impact on what a portfolio looks like.

 For example, a conservative investor might favor a portfolio with large-capitalised blue chip stocks like Nestle Plc or Nigerian Breweries in Nigeria for instance, broad-based market index funds, investment-grade bonds, and a position in liquid, high-grade cash equivalents.

In contrast, a risk-tolerant investor might add some small-capitalised growth stocks to an aggressive, large-cap growth stock position, assume some high-yield bond exposure, and look to real estate, international and alternative investment opportunities for his portfolio.

 In general, an investor should minimize exposure to securities or asset classes whose volatility makes him uncomfortable.

 Time value of money in portfolio allocation

The investor should know the value of money over a given period of time and the impact of inflation or volatility on the investments.

Impact of Time Horizon on Portfolio Allocations

Similar to risk tolerance, investors should consider how long they have to invest when building a portfolio. Investors should generally be moving to a more conservative asset allocation as the goal date approaches, to protect the portfolio’s principal that has been built up to that point.

 For example, an investor saving for retirement may be planning to leave the workforce in five years. Despite the investor’s comfort level investing in stocks and other risky securities, he may want to invest a larger portion of the portfolio’s balance in more conservative assets such as bonds and cash, to help protect what has already been saved.

Conversely, an individual just entering the workforce may want to invest his entire portfolio in stocks, since he may have decades to invest, and has the ability to ride out some of the market’s short-term volatility.

It is necessary for the investor to note that, both risk tolerance and time horizon should be considered when choosing investments to fill out a portfolio.

Asset allocation

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. The three main asset classes – equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.

 It has consistently been emphasized that there is no simple formula that can find the right asset allocation for every individual.

 However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

 Using different asset allocations for different objectives

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds.

Another individual saving for retirement that may be decades away typically invests the majority of his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the market’s short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put their money in a more conservative allocation despite a long time horizon.

 Age-based asset allocation

In general, stocks are recommended for holding periods of five years or longer. Cash and money market accounts are appropriate for objectives less than a year away. Bonds fall somewhere in between. In the past, financial advisors have recommended subtracting an investor’s age from 100 to determine how much should be invested in stocks.

For example, a 40-year old would be 60% invested in stocks. Variations of the rule recommend subtracting age from 110 or 120 given that the average life expectancy continues to grow. As individuals approach retirement age, portfolios should generally move to a more conservative asset allocation so as to help protect assets that have already been accumulated.

 Achieving asset allocation via life-cycle funds

Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to provide investors with portfolio structures that address an investor’s age, risk appetite and investment objectives with an appropriate apportionment of asset classes.

However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

Bonny Amadi