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Asset Allocation: The Key to a Successful Portfolio. Are You Paying Attention to Yours? Is asset allocation top of mind for you? We'll explain how you can look at asset allocation and why it's important in your portfolio.

By Melissa Brock

entrepreneur daily

This story originally appeared on MarketBeat

Depositphotos.com contributor/Depositphotos.com - MarketBeat

What does your portfolio asset allocation look like? Have you intentionally invested based on asset allocation?

If not, it's understandable. Most people don't consider how they'll allocate their investments when they first get started investing. They may try an investment, then invest in something else, thinking, "Why not add this to the mix?"

But if you do that, do you really have a good balance? How do you know, and how do you make sure your investments are allocated correctly? Let's find out.

What is Asset Allocation?

Put simply, asset allocation refers to implementing specific techniques to balance risk in a portfolio. You might divide assets into categories, such as bonds, stocks and real estate. Each type of investment "behaves" differently, so any downturns in one asset may be overcome by the success of another asset. It can protect you against loss and can remain one of the most important decisions you can make about your investments.

How to Effectively Allocate Your Your Investments

You know asset allocation is important, but how do you implement it into your portfolio? Let's go through the steps.

Step 1: Set specific goals.

Everyone invests with a goal in mind. You may not articulate it but in the back of your head you might say, "I'm going to invest in X because it's a nest egg for retirement.

Make a list of goals to figure out exactly why you're saving. Maybe you have the following in mind:

  • Save for retirement
  • Plan a round-the-world trip
  • Chuck money toward an emergency fund
  • Put money in an account for college
  • Save for a down payment on a house
  • Pay off the mortgage
  • Take a mini retirement
  • Renovate the basement or kitchen
  • Start the seed money for a business
  • Planning for a divorce

What other goals do you have on your list besides these? The more specific you can be in outlining your exact goals, the better you can allocate your assets.

You can include short- and long-term goals in your plan based on your current life situation. Note that it's okay if your plan changes as your life evolves. You can adjust as your life changes — you could experience a business failure or a bout with cancer. Your investment portfolio should reflect your current situation and look toward the future.

Step 2: Identify your risk profile.

What's your risk profile? If you're not sure, you probably actually already know on some level. Just ask yourself this question: How squeamish do you feel about losing money in general?

What's your gut feeling toward that question?

Once you answer that, you can start to piece together your investor profile and ideal investing approach. Are you more comfortable with one of the following?

  • Loss avoidance: Do you want to protect your money at all costs? A capital preservation approach means you want to preserve the money you have in your portfolio and take little extra risk. If this is your position, it's important to remember that certain investments offer limited growth opportunities — they're low-risk, low-reward investments.
  • Medium risk: If you have slightly more of an appetite for risk, you may look for an asset allocation that represents a medium amount of risk, including the potential for moderate capital losses. This type of allocation could net you regular income from interest and dividend earnings.
  • Growth: As you can imagine, the last profile involves a growth mindset, one that accepts risk through instruments with a higher risk profile. The more risk you assume, the greater your potential to accumulate wealth. Long-term growth should outweigh short-term losses because they have the best chance of appreciably growing over time, but you can also lose more money using this strategy as well.

Step 3: Choose the correct strategy.

You want to choose the right strategy in order to achieve all of your financial goals — including goals in the short term and in the long term. Let's take a look at several types of asset classes you can use to implement your overarching strategy:

  • Equities: Equities refer to shares of a company that you expect to rise due to capital gains or the generation of capital dividends. You can add many different types of equities to your portfolio to diversify it. A share of stock represents an equity interest in a company.
  • Fixed income: Fixed income includes investments in which the borrower or issuer must make fixed payments on a predetermined schedule to you, the investor. (Bonds are a good example of fixed income investments.)
  • Commodities: Commodities refer to basic goods used in commerce, such as beef, eggs, sugar, corn, soybeans and more.
  • Real estate: Real estate can offer another dimension to your portfolio, including cash flow, tax breaks, returns, an inflation hedge and more.

Are there more types of asset classes? You bet — including alternative asset classes. It's important to be discerning about which ones you choose, and make sure you diversify not only across asset classes, but within them as well. Understanding stocks, bonds, commodities, and more can form the right strategy and the best returns for your particular risk appetite.

Step 4: Acknowledge your financial experience (or lack thereof).

How well do you know how to navigate your own investments? Can you make sound decisions that reflect your risk tolerance and goals?

If not, you need to hire a fiduciary financial advisor to help you. If you need someone to help you lay the foundation of the house, incorporate that help and allow the right person to advise you through all of your various life stages. Through it all, make sure your advisor understands your overall objectives and investment strategy and keeps you on course and informed, particularly when market events occur and make your portfolio a little more unpredictable.

Choose the Right Asset Allocation

What's the best asset allocation? The idea is simple, though not always the easiest to disentangle. No matter what, the combination of your overall investment goals, risk tolerance and financial knowledge influences the right asset allocation and investment strategy for you.

Is it too late to adjust your allocation once you've already begun investing?

You can always switch your asset allocation, but remember not to do it just to react to market conditions. You can always update your goals and reevaluate your risk tolerance as the years pass. Get help doing it if necessary.

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