There’s no “one-size-fits-all” when it comes to investing, and for this reason there are different asset allocation models that will enable you to reach your investment goals, within the scope of your risk tolerance and time horizon. Each model emphasizes a different aspect of investing — one will perform better in certain markets, and not as well in others.
The basic idea is to create the portfolio using an asset allocation that makes use of all four models, but in different measures based on your preferences.
Let’s look at each of the four asset allocation models, keeping in mind none of them are — or need to be — a pure play in their stated categories.
An asset allocation model that emphasizes income will favor investments that tend to provide steady income with minimal risk of principal loss due to market fluctuations.
It’s important to keep in mind this type of asset mix includes a variety of assets that will involve a certain degree of risk — however minimal — as well as at least a small chance to participate in market growth. For this reason, performance of the model should be better than putting your money in something like a certificate of deposit.
Some of the assets you would hold in this allocation model include:
- US Treasury securities, in various maturities
- Corporate or municipal bonds
- High dividend paying stocks
Notice that while the model emphasizes income on all assets in the portfolio, there’s at least a small chance of loss particularly with bonds and stocks, depending upon market factors and the integrity of the issuing institution.
However, because of the slightly higher risk, such a portfolio should provide a rate of return at least a little above the interest and dividend yields.
2. Growth and Income
A growth and income model works much like the income model, in that it emphasizes income from all investments held in the portfolio. The primary difference is in the actual asset mix.
While the income portfolio tends to emphasize security of principal, a growth and income model looks to incorporate both income and the potential for capital appreciation. To do this, the growth and income model investments are primarily in dividend paying stocks, and less so in treasury securities or even bonds.
The idea is to generate steady income — such as dividend income — but to do so primarily from equity investments in stocks. This will enable the portfolio to provide capital appreciation, in addition to steady income.
Done properly, a growth and income asset allocation model can be one of the best performers over the long-term. This is because stocks that have a history of not only paying dividends regularly but also steadily increasing them represent one of the best long-term investments on Wall Street.
Under a growth asset allocation model, the portfolio will be invested primarily in equity type investments — mostly stocks. Though the portfolio may hold dividend income stocks, the primary emphasis will be on companies with above-average potential growth. Many of these stocks will pay no dividends whatsoever.
The portfolio tends to be invested in blue-chip stocks with a history of growth, as well as a small allocation in treasury securities. For the latter, enough is invested to at least represent a cash position from which to buy additional stocks in the future.
A growth oriented asset allocation model may hold a certain number of stocks belonging in the aggressive growth category — that is, stocks that fall into the high yield/high risk category. The idea of this model is to achieve more predictable growth than can be achieved with more aggressive investments.
4. Aggressive Growth
An aggressive growth asset allocation model will be invested primarily in high-return/high-risk equities. These positions held in such a portfolio may not provide any dividend income at all, and may also tend to avoid more predictable blue-chip stocks.
The investments held in an aggressive growth model would include stocks of companies most investors consider to be virtually speculative. Though the stocks can perform extremely well in rising markets, they are often subject to steep pullbacks in declining markets. For this reason, aggressive growth models are primarily for young people with a strong appetite for risk.
Stocks held in aggressive growth funds could include:
- Upstart companies with high performance but short track records
- Out of favor stocks — companies whose stock prices have recently been hit hard, but present speculative opportunities for rapid recovery
- Companies with high revenue growth, but little profit
- Concept stocks (like certain technology stocks) that represent cutting edge opportunities
- High risk/high reward international stocks — particularly those in developing economies
- Special plays in select industries or situations
Deciding Which Model Works Best For You
Though you might think you know which of these asset allocation models you would want to base your own portfolio on, there are actually objective factors to consider to determine which will be the best for you:
Determine your risk tolerance. If wildly fluctuating asset values will keep you up at night, you should probably go with either an income or growth and income model. If the prospect of scoring huge gains excites you — and the potential to take big losses along the way doesn’t bother you — growth or even aggressive growth may be the model for you. But you first need to determine how much risk you can comfortably handle.
Determine your goals and time horizon. If retiring in 30 years is your goal, you can and should emphasize growth or even aggressive growth. You have time to recover losses and the gains on growth type investments can be spectacular. On the other hand, if you plan to save money to buy a house in five years, you’ll want to be more conservative since you can’t afford to take a loss that will cut into your investment principal. Income or growth and income should be your preference.
Choosing an asset mix. Once you’ve identified your risk tolerance, investment goals and time horizon, you can set about deciding what types of assets will work best in your portfolio.
Establishing a rebalancing schedule. After setting your asset allocation, you will need to have a rebalancing schedule to make sure your portfolio model doesn’t become overweight in certain assets at the expense of others. This will be especially important in a growth and income model, where you’re trying to balance income and growth (risk). At a minimum, you should plan to rebalance at least once each year, so you can reset your portfolio to your desired asset allocation.
Readers: Which asset allocation model do you favor?