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What Is the Connection between Risk and Asset Allocation?

A. Garrett
A. Garrett

Risk and asset allocation share a symbiotic relationship. An individual’s asset allocation strategy depends on how much inherent risk he can tolerate from an investment venture. Risk tolerance is defined by the willingness of an individual to lose some or all of the capital he invests in a volatile asset class in exchange for the possibility of returns exceeding those yielded by safer investments or asset classes. Investing strategies determine the appropriate degree of risk and asset allocation for an individual investor based on his age, income needs, and long-term investing outlook.

Riskier, more volatile investments typically offer higher returns than low risk investments in order to encourage individuals to assume the associated risks. Risk and asset allocation determine whether an investor is considered aggressive or conservative. Aggressive investors usually allocate funds to asset classes that are riskier in order to get better results. Conservative investors are generally more concerned with mitigating risk and favor investment options that are less likely to lose the initial investment, despite not offering the potential for higher returns. There are three main asset classes containing potential investments of varying risks: stocks, bonds, and cash equivalents.

Woman holding a book
Woman holding a book

Stocks as an asset class historically have the greatest risk of loss and the highest potential for returns. Companies in need of capital, but hoping to avoid going into debt, issue stock. Individuals who buy stock gain equity in the company, but are not entitled to income or repayment of their initial purchase. As a result, stocks have less appeal than bonds or loans that pay interest and provide a timetable for reimbursement of the principal amount provided.

Business cycles and market demand constantly change and cause companies to make or lose money. This volatility makes stocks risky short-term investments. Stocks are attractive to investors because their underlying value grows over time as a company’s revenues increase, while bond and loan returns remain static. When attempting to balance risk and asset allocation, financial advisers usually suggest that aggressive investors who are young or can afford short-term losses allocate a high percentage of their investing capital to this asset class.

Debt financing represents another way for a company to raise money. Bonds are a form of debt. When an investor buys a bond, the price she pays, or the principal, is considered a loan. Each bond has a specific date, or maturity period, when the principal will be repaid. Additionally, bonds pay interest until the maturity date is reached.

Investing strategies accounting for risk and asset allocation usually suggest that conservative investors who are older or retired allocate a large proportion of their capital to this asset class. Bonds provide a stream of regular income that individuals with a low risk tolerance can depend on. Also, there is a guarantee of principal repayment. This makes bonds less risky than stocks, but because the interest and principal payments are fixed, there is less potential for reward.

Cash equivalents are savings deposits, money market accounts, and treasury bills. These are typically regarded as the least risky of all the asset classes because any funds deposited or invested are usually insured from loss by the government. Consequently, cash equivalents offer the lowest returns. Most financial advisers suggest that both aggressive and conservative investors have some funds in this category. However, the risk associated with this asset class is that inflation will increase at a higher rate than returns causing a loss in value over time.

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