Allocation in finance is the process where an individual or entity assigns portions of it portfolio across the major asset classes according to its appetite for risk, its investment goals and its relevant time horizons.
Since different asset classes have different general performance features, the allocation process can theoretically create quite nuanced and sophisticated portfolios by blending different assets at different proportions.
Allocation in Portfolio Theory
The most common process of asset allocation that takes place for individual portfolios is in the balance between equities and debt instruments.
When individuals are younger they have longer time horizons, higher investment goals and a greater appetite for risk. Therefore, most investment portfolios designed for young individuals tend to favor equities over debt instruments in their allocation to suit their investment needs.
By contrast, as investors age they have lower investment goals, shorter time horizons and less appetite for risk. This means that individual portfolio allocations tend to slowly shift from equities to debt instruments as the individual advances in years.
Other Common Allocation Concepts
While portfolio allocation is a wide and varied field, and more than a little contentious, there are a few other major features of modern portfolio theory that stand out from the rest.
Commodities are often added to a portfolio when the investor is willing to take on a higher degree of risk and to add assets that can be less cyclical or counter-cyclical than equities and debt instruments tend to be respectively.
Even a small allocation of a traditional portfolio’s capital to commodities can lead to a significant change in its overall performance.
Hedge fund allocations tend to play the same role as commodity allocations, as a greater source of risk and acyclical returns.
Gold has traditionally been used as a hedge against both risk and inflation in portfolios, though its use in allocation has declined recently from historical levels.
Cryptocurrencies are a growing source of asset allocation, often used to add a greater element of risk in the portfolios of young investors. Due to the enormous potential gains from cryptocurrency assets, even a small allocation in a portfolio can significantly increase overall returns.
Trading and Allocation
While day traders are not in the habit of building complex portfolios of long term investments, understanding asset allocation is essential to understanding the big picture ebbs and flows of asset value across all time periods.
By understanding how individual and institutional portfolios are built using asset allocation, day traders can predict the general shifts in asset value that take place as global risk appetites and the overall business cycles transition with time.
Modern portfolio theory and its influence on allocation beliefs will continue to drive the vast majority of investment decisions for the foreseeable future, so it is essential that day traders understand the general principles of portfolio theory that drive asset allocation decisions.
Asset allocation decisions are dominated by modern portfolio theory, and the overall directions of asset values will continue to be largely determined by how portfolios are adjusted according to risk perceptions and other major market forces.
Therefore, it is essential that day traders understand the basic principles of asset allocation in modern portfolio theory.