Investors can buy many different types of securities, but people who are attempting to achieve optimal asset allocation attempt to create a portfolio of investment instruments that provides them with the best chance of reaching their investment objectives. Many investors have several different investment objectives as many people attempt to reach short-term goals such as saving money for a home down payment along with reaching long-term goals such as raising money for retirement. In such instances, investors must determine the optimal asset allocation for each portion of their investments.
The first step in determining optimal asset allocation involves defining an investment objective and a timeline to achieve that objective. In many countries, people typically retire somewhere between the ages of 60 and 70. Someone who has an objective of saving for retirement, for example, can determine their timeline by simply subtracting their age from 60 or 70. Having determined an objective and a timeline, an investor can figure out how best to reach their investment goal.
There are many different investment asset classes but equities, income securities and cash equivalents are among the most commonly known classes. Equities such as stocks provide investors with an ownership stake in a company and the opportunity for uncapped growth. Income securities such as bonds may provide an investor with some opportunity for growth if the bonds are bought at a discount, but bonds and other debt instruments primarily provide investors with recurring income payments. Cash equivalents such as money market mutual funds or commercial paper may provide investors with a small amount of growth or income but these securities provide investors with a high degree of principal protection. Those trying to create an optimal asset allocation model must decide which of these asset classes best serves their needs.
Every type of investment exposes investors to some degree of risk. Equities have no principal guarantees, and cash equivalents provide little or no growth which means investors lose spending power due to the impact of inflation. Bonds expose investors to both principal risk and inflation risk. Therefore, investors must decide how much they can afford to invest in each type of security in order to reach the optimal point at which the balance between the potential risk and rewards is at a point that the investor is comfortable with. Investors can create an optimal asset allocation portfolio by deciding how much needs to be made, and how much loss can be afforded.
Many investment firms sell mutual funds that contain asset allocation models that have been designed to suit individuals with certain levels of income or people of a certain age. Some investment firms sell asset allocations funds that contain a number of variations so that each investor can adjust the fund make-up to account for their age, investment time horizon, risk tolerance and income level. Therefore, investors can acquire well-balanced portfolios without having to purchase all of the stocks, bonds and cash equivalents that form the portfolio.