Asset Allocation Risk Strategy in Investment Portfolio Management

Any good retirement investment strategy starts with deciding on how you will manage the asset allocation risk of your investment portfolio. Before you even start looking at specific investment vehicles, you have to decide which types of asset classes to put your money.

Managing your asset allocation risk starts with deciding which investment vehicles you want to invest in. There are many asset classes, each with it's own set of risks and potentials for returns. Asset classes are broader types of investments, like bonds, stocks, real estate, and commodities.

Each has it's own set of risks and you must first decide who you will assemble these asset classes into an effective asset allocation risk management strategy. We're not going to go in depth with modern portfolio theory. This is just the basics on picking broader asset classes.

Asset Allocation Risk Diversification

A healthy and smart investment portfolio management strategy begins with asset allocation diversification. Diversification allows an investor to spread the risk around to a broad spectrum of investment vehicles.

It's the principle of not putting all your eggs in one basket. If one investment vehicle fails to offer a return, you have other financial assets in your portfolio that can still make a return for you.

But diversification isn't about just finding good stocks to invest in. It also involves having different types of broader asset classes like bonds and real estate.

As part of your diversification, you should also learn how to hedge your investments with financial instruments like options, futures and commodities. For example, if you own a particular stock, you might want to consider buying an option in that stock to hedge your investment.

Asset Classes and Spectrum of Risk

There is a spectrum of risks depending on what type of financial asset you decide to invest in. A healthy investment portfolio management strategy will have assets across this spectrum of risk.

Cash

The safest point in that risk spectrum would be cash in a bank account. The safest asset class would be a savings account. Many offer interest rates that may come close to covering a loss due to inflation.

But the risk of you losing any of that money is close to none, again, other than to inflation. Cash has the lowest asset allocation risk attached to it.

Money Market

The next safest financial asset class would be money market instruments. This would include things like certificate of deposits, commercial paper and treasury bills.

The money market is a category in the fixed-income market. Although most small investors can't directly buy these instruments, there are plenty of money market funds, or mutual funds, that consist of these money market securities.

You can find a money market fund in virtually any financial institution including your local bank branch. You can also usually get started in it with very little cash and low or no fees.

Bond Market

Another safe asset class is in the bond market. Bonds are basically debt instruments. That means you are essentially lending money to the institutions that issues bonds.

Examples of this would be corporate bonds, municipal bonds, and Treasury bonds. Buying these bonds is basically these institutions borrowing the money. Bonds generally have a fixed rate with a fixed income making it a safe mode of investing.

Equities Market - Stock Market

The equities market, more commonly known as the stock market, is the opposite of bonds. Instead of lending money with a specific rate of return, you are buying ownership shares in the company.

That means you take on more of the risk with the company you are buying. It also means you have a potential for greater returns.

There are other ways to invest in the equities market other than to pick individual stocks. You can buy and sell shares in an ETF, an exchange traded fund. These are managed funds with a variety of different securities that you can trade like a normal stock.

You can also invest in index funds. These are ways to invest in the stock market. Some include the Dow Jones index funds and S&P 500 index funds. Both of these funds follow the stock indices respectively.

Derivative Markets

The derivative markets is probably the riskiest type of investment instrument with the highest asset allocation risk. Examples of derivative instruments are futures and options.

Futures and options has no inherent value and is contingent upon the values of other assets like stocks, indexes, commodities and bonds. But with the risk also comes the potential rewards.

Many adventurous investors trade these derivative market instruments, many times at the cost of their entire portfolio and sometimes with great success.

These are the main asset classes that you have to look at when you are putting your investment portfolio together. Once you decide what percentage of your portfolio you want to devote to what asset class, you can then drill down to more specifics like what particular instrument you want to put money in.

Considering the asset allocation risk strategy begins by looking at these broader financial instruments and deciding how to mix and match your portfolio.

The contents of this page is purely the opinion of the author and should not be taken as financial advice.  All investments should be made after consulting a qualified financial adviser.