Asset Allocation & Effects on Investment Return
The appropriate asset allocation positively affects investment return by reducing the amount of risk in the portfolio. Correlation is a key component of asset allocation, as is type of investment. An investor seeks to allocate assets in a manner that allows the decrease in return of one to offset an increase in the return of another so that his overall portfolio does not decrease beyond a certain level of return.
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Asset Allocation
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Asset allocation involves appropriately dividing a person's portfolio among different types of investments and investment with different levels of risk. Risk affects return. An investor only accepts a high level of risk with the suggestion of a high level of return. Asset allocation also involves choosing stocks that typically move opposite each other, so the decline in one is offset by an increase in another.
Types of Risk and Correlation
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Two types of risk exist -- systematic and nonsystematic. Market driven risk, which is nondiversifiable, is systematic. Diversification through correct asset allocation will not rid a portfolio of this type of risk.
Diversification of nonsystematic, or unique, risk is possible through correlation. Correlation is the manner in which investments move related to each other. When they move exactly opposite, they are perfectly negatively correlated. Correct asset allocation seeks to have assets that are relatively uncorrelated so they do not move together and cause the return of the whole portfolio to decline.
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Types of Investments
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Types of assets chosen by the investor are also a prominent part of asset allocation. Accurate allocation uses stocks, bonds, money market funds and possibly annuities or other types of securities. Bonds provide fixed income, or periodic distribution of interest, whereas stocks do not most of the time. There generally is more safety (less risk) in bonds and even more in money market funds, than in stocks. This provides diversification for the investor.
Overall Effect on Return
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Good diversification, or asset allocation, will decrease risk and allow the investor to achieve her appropriate level of return. Every investor seeks to achieve a certain level of return to reach a certain monetary goal. Asset allocation helps by lowering the possibility the portfolio will experience a period of significant decline or, during recessions, a lower level than other investors.
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