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Beginning an investment journey can be daunting, and even if you’ve already started, you may still have questions. What should you invest in? Why is everyone talking about diversifying their portfolio? What is asset allocation?
Since it is nearly impossible to predict with certainty whether one investment is better than another, many investors choose to diversify their investments by allocating their funds, also known as their capital, to include many different asset types.
Essentially, they are investing in many different things to stabilize or neutralize the volatility of individual investments so that over a long period of time, they may see more consistent returns.
Simply put, asset allocation refers to investment strategies that tell you how much money to put into which asset classes to maximize returns. This article will cover the basics.
- What Is Asset Allocation?
- Why Is Asset Allocation Important?
- What Is Modern Portfolio Theory?
- What Is Efficient Frontier Theory?
- What Are the Primary Asset Allocation Models?
- Strategic Asset Allocation Vs. Tactical Asset Allocation
What Is Asset Allocation?
Asset allocation is allocating your money into various different asset classes (e.g., stocks, bonds, and cash investments) to balance short term volatility with long term stability.
While part of it is about minimizing risk and maximizing returns, asset allocation goes deeper than that. There will always be risk associated with investing, and the goal will usually be to maximize returns.
Asset allocation is about deciding the exact amount of capital to invest into each asset class so that you experience the most balanced, stable portfolio possible.
Why Is Asset Allocation Important?
For the sake of clarity, your portfolio is just the combination of assets that you choose to invest in. So why do you want asset allocation within your portfolio?
To put it simply, investment returns may vary based on many factors. For example, an investment in real estate may be more lucrative one year when the housing market is up, but not as much the next if the housing market drops.
At the same time, an investment in a different commodity or asset class that is less correlative to the stock market, such as agricultural land, may be more profitable at different times than a standard residential or commercial real estate investment, the values of which may fluctuate more than agricultural land in a down economy. By investing in a mix of real estate assets, the investor is more likely to see consistent returns across their portfolio.
What Is Modern Portfolio Theory?
Modern Portfolio Theory (MPT) assumes that the investor is trying to minimize risk and maximize return by investing in a diverse spread of assets. Essentially, for the amount of risk you take with an investment, what can you expect in return?
Developed by economist Harry Markowitz, it set a precedent for investing as a strategy and became the baseline for portfolio management.
MPT is built on the idea that diversifying your portfolio to include different asset classes will generate a more consistent, higher rate of return than investing all of your money into one asset class.
Have you ever heard, “Don’t put all of your eggs in one basket”? Think of MPT like that; if you only invest in one thing, and that asset loses value quickly, you will lose money quickly.
Conversely, if you invest in multiple assets, and one of those assets drops in market value, but another goes up in market value, you are more likely to offset the loss on one investment with a gain on another.
Some argue that Modern Portfolio Theory is irrelevant today, with the many alternative options out there. While the investing landscape changes every day, the basic principles of MPT do not: diversification and balance.
What Is Efficient Frontier Theory?
The Efficient Frontier Theory (EFT) is the quantitative basis of MPT. It is the idea of having a set of portfolios that optimize returns and minimize risk to create an optimal portfolio, or an efficient portfolio, based on a quantitative, mathematical analysis.
Keep in mind that MPT and EFT assume that investors are always going to choose the least risky portfolio option given the return they are seeking, which may not always be true. Learning about many different strategies and understanding the different asset allocation models may help you decide what strategy best fits your goals.
Now that you have a grasp on what asset allocation means, let's break down our three major asset allocation models.
What Are the Primary Asset Allocation Models?
Portfolio asset allocation models generally refer to the type of portfolio that can be built while taking into account the investor’s goals, risk tolerance, and timeline.
Remember, asset allocation is about how much money you’re putting into which assets, and why. Asset allocation model types designate what percentage of your capital should be allocated to what asset.
While there are many different types of asset allocation models, and there is no standard set of models used in the financial industry, you will most commonly hear about these three traditional asset allocation models:
- Income Portfolio: Approximately 70% in bonds, and 30% in stocks.
- Growth Portfolio: Approximately 70% in stocks and 30% in bonds.
- Balanced Portfolio: Approximately 40% in bonds and 60% in stocks.
Income Asset Allocation Model
Income asset allocation models are relatively self explanatory: they are intended to generate short-term income. The investor generally invests most of their capital in bonds, an asset type that has potential to pay out in the short-term. This type of model is less likely to grow wealth over a long period of time.
Growth Asset Allocation Model
Growth model portfolios are designed to generate growth over a longer period of time. In this model, the investor would invest most of their capital in stocks that may have less potential for short-term supplemental income in hopes that the stocks they’ve invested in will slowly grow in value until they are fully realized and able to cash out a larger amount all at once.
Balanced Asset Allocation Model
Balanced models are a mixture between income and growth, and there is generally a 60%/40% split between investing in stocks and bonds. This strategy is intended to balance out long term growth with short term income.
One shortcoming of these traditional portfolio splits is that they don’t account for the many alternative investments available to investors. However, these models may still serve as starting points for a more complex, individualized allocation strategy.
Strategic Asset Allocation Vs. Tactical Asset Allocation
Strategic asset allocation (SAA) is a long-term investment strategy that balances risk with return. Within this strategy, the investor will only periodically adjust and rebalance their portfolio. This is a buy and hold strategy intended to grow wealth over a longer period of time.
Tactical asset allocation (TAA) is a strategy that requires more tending to. With TAA, the investor closely watches market conditions and adjusts their asset allocation to attempt to reap short term profit benefits. This is a more hands on approach, and the investor must actively manage their investments in an effort to capitalize on short-term profits.
Every investor’s portfolio will look different depending on their needs, timeline, and the level of risk they’re willing to take. The one constant when it comes to a well managed portfolio is this: a strategic allocation of assets. To recap:
- Asset allocation is spreading your investments across multiple assets to balance short term volatility with long term stability.
- MPT is portfolio management based on a mathematical analysis to determine an optimal split of assets.
- It is important to note that alternative asset options are continuously expanding and can be a contributing factor in achieving a well-balanced portfolio.
Learning about asset allocation and how different asset classes perform will help you start your investment journey the right way.
If you’re interested in the expanding asset class of land and how investors incorporate land investments into their overall investing strategies, visit Why Farmland?
Please note: this article is meant to be a topical overview and, as such, does not include specific financial advice. Every situation is unique, and you should consult with a licensed attorney, accountant, and/or financial advisor prior to entering any written contract or verbal agreement.