Risk and Asset Allocation II: Risk Categories

Risk and Asset Allocation II: Risk Categories
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Understanding risk appetite and the importance of asset allocation

Different investors have different limits to the risk they are willing to take. The higher the ability of an individual to take risk, the higher the person’s risk appetite. Some investors can stomach much more risk than others.

Can you sleep like a baby at night knowing your investment went down 25%?

Sometimes it isn’t just your ability to stomach risk, there are other things competing for your resources (money) so there is so much you can do.

In general, the younger you are the more risks you SHOULD take.
DO NOT ENTER.
Photo by Raúl Nájera / Unsplash

You have less responsibility and have more time to get back up. As you get older, you get more risk-averse, and you turn to conservative investments. These are investments with fewer risks.

Investors can be categorized base on their risk appetite as:

  • Very Conservative
  • Conservative
  • Moderate
  • Aggressive
  • Very aggressive

So to balance risk, we divide our capital among different investment classes.

ASSET ALLOCATION

Asset allocation is the practice of dividing an investment portfolio into different types — or classes — of assets, such as stocks, bonds, and cash.

In an investment portfolio, there are competing needs such as

  • Growth
  • Liquidity
  • Income production

The following are the reasons why you need to allocate assets:

  • Asset allocation ensures optimal returns.
  • It ensures that there is sufficient liquidity so that when one off opportunities come up, you can gain from them. Or when some other unexpected expense come up, you would not need to dip into an investment to cater to such need.
  • Asset allocation help achieve financial goals. When you are looking for a steady stream of income, your portfolio would be different for one looking for growth. Whatever your goal might be, you can adjust your portfolio to reflect that.
  • Asset allocation helps to minimize taxes. With the right amount of assets and accounts, you can significantly reduce your tax output in the long run.

Asset allocation depends on the investor's risk tolerance and time horizon.

Asset allocation is one of the most important decisions that an investor will make for their financial future.

By choosing the right mix of stocks, bonds, cash, and other asset classes, you can ensure that you are set up to reach your financial goals.