The Asset Allocation Investment Process
Over the years, financial experts have provided investors with different theories and ideas on how to invest effectively. The one concept that almost everyone seems to agree upon is the need to diversify.
Although the stock market has historically trended up over time, making it an attractive investment vehicle for the long-term investor, bear markets and corrections are a reality. An ill-timed market dip can knock an aggressively allocated retirement portfolio off track.
The challenge, of course, is trying to determine when one cycle will end and another will begin. Thankfully, that is not necessary and, as it turns out, timing the market rarely works.
Understanding Asset Allocation
The practice known as asset allocation is the most effective method for most investors to balance a portfolio among various types of investments and shield it against offsetting losses. As many investors realize, the three main asset classes—stocks, bonds, and cash alternatives—are often co-classified (in the same descending order) as higher-risk, lower-risk, and lowest-risk investments. Within each asset class, investment risk can be further broken down. For instance, a large cap stock from a major corporation with a track record of stability is usually considered a lower-risk investment than a stock issued by a lesser-known company with a smaller market capitalization. On the other hand, the small cap stock generally carries the potential for higher returns.
Developing Your Strategy
After deciding that asset allocation makes sense, the primary objective is to decide how to diversify your portfolio. For this task, and for the ongoing maintenance it will require, your Financial Advisor is an invaluable resource. At Wintrust Wealth Management, we can help you develop an asset allocation strategy that is aligned with your investment objectives and risk tolerance. To make the process simpler, we have developed investment strategy models that cover a wide spectrum of asset allocations and serve as a guide to asset class breakdowns for various investment styles. For instance, investors seeking growth and income with a moderate risk tolerance would want approximately half of their portfolio invested in stocks, a third in traditional fixed income investments, and the remainder in alternative income investments with a marginal amount in cash alternatives. A growth-oriented, long-term investor, on the other hand, would be almost entirely invested in stocks.
Diversification as a theoretical concept is easy to understand but until the last 20 years has been difficult to implement. Most of us recognize the need to diversify our investments among stocks, bonds, and cash alternatives. But how do you determine what percentages to allocate among them? In the 1950s a concept was developed called “modern portfolio theory” to address this very concept.
Two Major Tenets of Modern Portfolio Theory
1. Investors are risk averse. That means given the choice between investments with the same general returns, they will choose the least risky.
2. The more risk an investment has, the greater the return potential should be. Because investors are risk averse, they will not choose investments with greater risk without the possibility of greater return.
Financial Advisors use these tenets in the development of portfolios for investors. Our asset allocation models are indicated in the chart below. Moving left to right, the chart shows allocation recommendations with higher levels of portfolio risk and correspondingly higher levels of expected return.
Investors with similar investment objectives may have different risk tolerances, therefore these asset allocation models provide recommendations for investors with different degrees of risk tolerance.
What Kind of Investor Are You?
Using the investment planning process Envision®, our Financial Advisors can determine which investment objective is right for you from among the many shown on the chart below
Conservative Income investors seek the maximum amount of income consistent with a modest degree of risk. They are willing to accept a lower level of income in exchange for lower risk. Higher risk investments, such as high yield bonds and some equities, are typically not a large percentage of the account.
Conservative Growth and Income
Conservative Growth and Income investors seek the maximum growth and income consistent with a relatively modest degree of risk. They are willing to accept lower potential returns in exchange for lower risk. Equities, generally dividend paying equities, may be some percentage of the account.
Conservative Growth investors seek maximum growth consistent with a relatively modest degree of risk. They are willing to accept lower potential returns in exchange for lower risk. Equities may be a significant percentage of the account.
Moderate Income investors seek to balance the potential risk of capital loss with increased income potential. Higher risk investments, such as high yield bonds and some equities, may be some percentage of the account.
Moderate Growth and Income
Moderate Growth and Income investors seek to balance the risk of capital loss with higher potential growth and income. High yield bonds and equities, generally dividend paying equities, may be a significant percentage of the account.
Moderate Growth investors seek to balance the potential risk of capital loss with their goal of higher potential growth. Equities may be the primary asset in the account.
Aggressive Income investors seek a significant level of income, are financially able and willing to risk losing a substantial portion of investment capital, and, due to their long term horizon or other factors, they employ higher risk, more aggressive strategies that may offer higher potential income. Higher risk investments, such as high yield bonds and some equities, may be a significant percentage of the account.
Aggressive Growth investors seek a significant level of growth, are financially able and willing to risk losing a substantial portion of investment capital, and due to their long term time horizon or other factors, they employ higher risk, more aggressive strategies that may offer higher potential returns. Higher risk investments such as equities may be as much as 100% of the account.
Aggressive Growth and Income
Aggressive Growth and Income investors seek a significant level of growth and income, are financially able and willing to risk losing a substantial portion of investment capital, and due to their long term horizon or other factors they pursue high risk, more aggressive strategies that may offer higher potential returns. High yield bonds and equities, generally dividend paying equities, may be the primary assets in the account.
Asset Allocation Over Time
It is important to realize that asset allocation can shift over time due to varied performance of different asset classes. Also, as your personal circumstances change, you may want to reconsider your investment objective and risk tolerance. To learn more and review your current asset allocation, contact a Wintrust Wealth Management Financial Advisor today.
Our professionals can help you construct a strategy customized for your unique needs and best positioned to help you achieve your long-term goals.
1. Source: Morningstar. REITs: Wilshire US REIT TR USD; Emerging Market Stocks: MSCI EM NR USD; International Stocks: MSCI EAFE NR USD; Small Cap Stocks: Russell 2000 TR USD; High Yield Bonds: Barclays US Corporate High Yield TR USD; Large Cap Stocks: S&P 500 TR USD; Commodities: Bloomberg Commodity TR USD; Investment Grade Bonds: Barclays US Agg Bond TR USD; Cash Equivalents: Barclays US Treasury Bill 1-3 Mon TR USD.
2. Asset allocation weights are approximate and may shift over time. Envision® is a registered service mark of Wells Fargo & Company and used under license.
Past performance is not a guarantee of future results. Diversification does not guarantee a profit or protect against loss. Return is measured by projected compound annual growth rates based on Wells Fargo
Advisors 2010 Capital Market Assumptions for the associated asset class. Downside risk is the return threshold that one would expect returns to fall below only once in 20 years. This means there is a 1-in-20 risk (5% probability) that the loss over a one-year period could be greater than the downside risk calculation.
Money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although these funds seek to preserve the value of your investment at $1 per share, it is possible to lose money by investing in these funds.
Asset allocation/diversification cannot guarantee a profit nor protect against loss in a declining market.
Equities: Equity investments refer to buying stocks of United States companies as well as companies outside of the United States. The market capitalization of U.S. companies is used to group large, medium (mid) and small companies. The investment return to the owner of stock (shareholder) is in the form of dividends and/or capital appreciation. The market capitalization of companies is used to group large, medium (mid) and small companies. Shareholders share in both the upside potential and the downside risk. Dividends are not guaranteed and are subject to change or elimination. The prices of small company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share-price volatility.
Fixed-income securities (Bonds): Bonds are promissory notes of a United States corporation or federal government entity (taxable bonds) or a state or local government entity (tax-exempt or municipal bonds). Bonds usually make a series of interest payments followed by a return of principal at maturity. If sold prior to maturity, the price that can be obtained for a bond may be more or less than face value, depending on interest rates at the time the bond is sold and the remaining term of the bond. Investing in fixed-income securities involves certain risks such as market risk if sold prior to maturity and credit risk, especially if investing in high-yield bonds, which have lower ratings and are subject to greater volatility. All fixed-income investments may be worth less than original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. Fixed income securities include Treasuries (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year), government-related issues (i.e., agency, sovereign, supranational and local authority debt) and corporate bonds.
Alternative income: Distinct from traditional fixed income is the alternative income category, which includes high-yield debt, emerging markets debt and REITs. Such investments offer greater income potential but also higher levels of risk than traditional forms of debt.
Commodities: Basic goods used in commerce that are generally interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions. Buying commodities allows for a source of diversification for those sophisticated persons who wish to add commodities to their portfolios and who are prepared to assume the risks inherent in the commodities market. Any purchase represents a transaction in a non-income-producing commodity and is highly speculative. Therefore, commodities should not represent a significant portion of an individual’s portfolio.
Cash Alternatives: This category includes short term, liquid, interest-bearing investments having maturities of less than one year. It is usually used for temporary investment purposes pending a distribution or other transaction. Money market accounts and Treasury bills are considered cash equivalents. Money market funds charge fees; cash returns are estimated net of typical fees.
Where will your financial journey take you? A Financial Advisor helps you navigate the terrain, avoid pitfalls, and keep you on track to achieve your financial goals.