Chapter 3. Asset Allocation
In their well-known textbook, Investments, Zvi Bodie, Alex Kane, and Alan Marcus define asset allocation as "the distribution of risky investments across broad asset classes." Taking a broader view, asset allocation can be defined as the process of investing assets in a manner reflecting one's unique ability, willingness, and need to take risk. Consider these as three different tests.
The Ability, Willingness, and Need to Take Risk
The Ability to Take Risk
An investor's ability to take risk is determined by four factors: (1) investment horizon, (2) stability of earned income, (3) need for liquidity, and (4) options that can be exercised should there be a need for "Plan B."
Let's begin with the issue of the investment horizon. The longer the horizon, the greater is the ability to wait out the virtually inevitable bear markets. In addition, the longer the investment horizon, the more likely equities will provide higher returns than fixed-income investments.
Table 3.1 provides a guideline for this part of the ability to take risk.
Investment horizon is not the only consideration: The individual's labor capital must be considered. This asset is often overlooked because it does not appear on any balance sheet.
An investor's ability to take risk is impacted by the stability of their earned income. The greater the stability of earned income, the greater the ability to take the risks of equity ownership. For example, a tenured professor has a greater ability to take ...