Simply stated, financial advisors build asset allocation models by (1) taking historic market data on classes of securities, individual securities, interest rates and various market conditions; (2) applying projections of future economic conditions and other relevant factors; (3) analyzing, comparing and weighting the data with computer programs; and (4) further analyzing the data to create model portfolios.
There are three key areas that determine investment performance for each asset class:
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1. Expected return. This is an estimate of what the asset class will earn in the future-both income and capital gain-based on both historical performance and economic projections.
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1. Risk. This is measured by looking to the asset class’s past performance. If an investment’s returns are volatile (vary widely from year to year), it is considered high-risk.
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1. Correlation. Correlation is determined by viewing the extent in which asset classes tend to rise and fall together. If there is a high correlation, a decision to invest in these asset classes increases risk. The correct asset mix will have a low correlation among asset classes. Correlation coefficients are calculated by looking back over the historical performance of the asset classes being compared.
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Tip: The ideal asset allocation model for you will change over time, due to changes in your portfolio, market conditions and your individual circumstances. There will probably be shifts in the percentages allocated to asset classes, and possibly some changes in the asset classes themselves.
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