What is Asset Allocation

Assets Allocation means dividing the investment portfolio among different assets.

Asset allocation is an integral part of portfolio diversification and aims to balance the risk and return by adjusting financial assets in a portfolio in accordance with an investor’s goals and expectations, horizon and risk tolerance.

There’s no one simple formula for asset allocation that fits all investors. Financial analysts consider that the asset allocation is one of the most important steps the investors make.

Equities, fixed-income and cash equivalents are of the three main asset classes which definitely have different levels of risk and return.

Asset allocation mainly depends on the correction of the assets in the portfolio. There are three types of asset correlation: positive, negative and zero.

  • Positive correlation - does not reduce portfolio risks as the returns are directly related with the risk level.
  • Zero correlation - implies no relationship between returns on two assets. By combining two securities with zero correlation, the risk may be reduced but not eliminated.
  • Negative correlation - suggests that the returns are in inverse linear relation which can eliminate the risk altogether.

By changing the desired level of return, efficient asset allocation in the portfolio also changes. Therefore, it is possible to create more than one efficient portfolio with different risk-return ratios.

What is Asset Allocation

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Modern Portfolio Theory

Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.
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