How to Achieve Optimal Asset Allocation

How to Achieve Optimal Asset Allocation

Submitted by adil on Fri, 11/22/2013 - 13:33

Trading stocks is not just about timing the best entries and exits, to make great returns. It is about optimal returns. The risks return tradeoff states, that greater the risk taken higher is the reward. In the world of financial markets however, it can mean life and death for day-traders. You cannot make more profits by simply taking more risks. Such blatant risk taking will likely lead you to huge losses. However, you can make more profits by taking calculated risks.

A trader needs to stay always in a balance between taking appropriate risk exposures with expected returns. The first and basic step in this direction is to develop a diversified portfolio of assets. In other words, you must allocate your capital in different assets while you trade. This way you do not put all the eggs in one basket. Hence, your entire capital is saved from becoming a slave of one commodity or stock.

Allocating capital in different assets does not expose it in entirety to a similar type of risk. Optimal allocation of asset happens when maximum returns are obtained with most limited amount of risks. In practice, however, this ideal situation is not perfectly achievable. Nevertheless, striving to do so does have its obvious advantages in lower risks of losing money and higher probability of making some.

Before going about to build your optimal allocation, you must know the risk-return characteristics of an asset. For example, government bonds are the least risky asset you can trade in, however, its returns are also very low. On the other hand, if you invest in the stock of blue chip companies, you will be facing significantly higher risks compared to government bonds, and at the same time, you will gain much better returns in comparison to government bonds. Each asset's risk and return profile is different from the other, and various elements need consideration in this regards. You can use ratings flushed out by rating agencies to gauge an asset's profile.

Every trader has his own risk appetite. You may have lots of poker won easy money that you may be willing to put at risk, that is, your risk appetite is high. If you are a pensioner and have the same amount of money, you would tread carefully, that is, your risk appetite is low. Based on your risk appetite you follow a conservative or aggressive approach in making an assets profile. If your risk appetite is low, you will follow a conservative approach where you will build a profile with least risky assets. If your risk appetite is high, you will follow an aggressive approach where you will build a profile with riskier assets.

You can always follow an asset allocation strategy, which is based on an investor's risk appetite, time period and goals. There are at least six different types of strategies you can follow, they are strategic asset allocation, constant-weighting asset allocation, tactical asset allocation, dynamic asset allocation, insured asset allocation and integrated asset allocation.