Asset Allocation & Diversification to Reduce Investment Risks
Risk is an essential condition of our existence. Usually, when someone talks about risk, he means that there is a possibility of unfavorable development of further events. In everyday life, such a high-quality, very vague definition is quite enough. But it is far from enough when considering a specific category of risk - investment. It requires a more precise approach.
Asset allocation is your strong suit? It’s time to get some profit with the KickEX exchange! By investing, we expect to receive a certain income. In reality, that income may be slightly different. It may even turn out to be an overdrawn situation, i.e. the investment may be unprofitable. Besides, it is impossible to guess the exact result with one hundred percent probability. Therefore, one should carefully approach this issue and learn how to manage one’s risks. If you want to read more about a similar subject, check out Introduction to Risk Management.
The risk cannot be fully eliminated, but it can be mitigated according to individual investment goals. Asset allocation and diversification are very key concepts in defining risk parameters.
Asset allocation & Diversification definitions
Asset allocation involves breaking down the investment portfolio into distinct asset categories. The process of determining which combinations of assets to include in a portfolio is very personal. The distribution of assets that will be best for you at a given moment in life depends mainly on your time horizon and risk tolerance.
The time horizon is the expected number of months, years, or decades that you will invest to achieve a specific financial goal. The long-term investor can feel more confident investing in risky or more volatile assets, as he is able to weather the inevitable ups and downs of our markets.
Risk tolerance is your ability and willingness to lose some or all of your initial investment in exchange for large potential returns. An aggressive investor, more resilient to risk, is more willing to risk losing money in order to get better results. A conservative investor who is less tolerant of risk chooses investments that will retain their value.
Diversification is a strategy that can be summed up in the perennial adage "Don't put all your eggs in one basket." This strategy involves distributing money among different investments in the hope that if some investments fail, then other investments will compensate for these losses.
Thus, in addition to the allocation of your investments among stocks, bonds, cash equivalents, and cryptocurrency assets, you also need to distribute your investments within each asset category. The key is to find investments in segments of each of the asset categories that can behave differently in different market conditions.
Why is asset allocation so important?
By including in the portfolio different categories of assets, the return of which can rise or fall in different market situations, the investor can protect himself from significant losses. Historically, earnings for major asset categories have not moved up and down at the same time. Market conditions that caused one of these asset categories to perform well often resulted in the other asset category performing average or poor. By investing in more than one asset category, you reduce the risk of losing money and the overall return on your portfolio becomes smoother. If the return on one of the investment asset categories falls, you can offset your losses with a higher return on another asset category.
Asset allocation is important as it greatly affects whether you achieve your financial goal. If you do not include risky assets in your portfolio, your investments will not be able to show high returns to bring you closer to your goal. For example, if you are saving money for long-term goals, most financial experts will advise you to include at least some stocks or equity funds in your portfolio. On the other hand, if you include too many risky assets in your portfolio, the money may not be available when you need it.
Conclusion
Investment management is a simple but not easy task. Because without a firm adherence to a long-term investment strategy based on scientifically sound asset allocation, one can suffer large financial losses and become disillusioned with this activity.
All investors face two main risks - inflation and volatility. By changing the structure of the portfolio, one of the risks can be reduced, but only by increasing the other. The determining factor in choosing a strategy is the investor's time horizon. With short investment periods, volatility is more dangerous. It may turn out that at the time of exiting the investment, its return is negative. With significant investment periods, the risk of inflation comes to the fore.
However, regardless of the investment time horizon, wide diversification using many unrelated assets can dramatically improve the performance of the investment portfolio as a whole.
