All investors must balance risk and reward. If you purchase shares in a company and the company increases its earnings and profits, your shares may increase in value. If the company instead suffers losses, your shares may decline. Since it's rare for the majority of investments to lose value at the same time, you can diversify away some risk by allocating money to different assets at the same time.

Traditional investment management identifies three allocation strategies: conservative, moderate and aggressive. Each asset allocation model is defined by the level of risk an investor is willing to assume.

The conservative investor may be wary of market fluctuations and unwilling to commit money toward assets with a history of downside capture. An aggressive investor, sometimes called a "growth investor" by asset managers, places more value on maximizing investment returns and less value on preserving the absolute level of pre-existing contributions. The moderate investor is more difficult to define, but generally favors an allocation that targets above-inflation returns and avoids the most risky markets.

The Conservative Allocation Model

A conservative allocation model is constructed with a few rigid principles in mind. Chief among these principles is limited fluctuation in investment value, or preservation of capital, but other principles include a focus on yield and a sizable concentration in high-quality bonds.

Until more recently, conservative allocations tended to generate sufficient returns from diversified municipal bonds, utilities, money market funds and even some tactical cash positions. Ultra-conservative bond portfolios saw 25% annual growth in the early 1980s, but it has generally become much more difficult to find strong performing conservative allocations.

In recent years, low interest rates have suppressed coupons for traditional debt instruments. Investor concerns about recent economic volatility, coupled with aggressive central bank purchases, have bid up the prices for Treasury and other investment-grade bonds, which drove down yields.

Today's conservative investors are forced to accept either lower returns or a higher risk of loss. A modern conservative asset allocation typically includes large-cap U.S. stocks, short-term government bonds, utilities and telecommunications tilts, and maybe even some high-yield municipal bonds.

The Moderate Allocation Model

A moderate allocation model is not easy to define. Since everyone's sense of risk is a little different, one investor's moderate portfolio may be considered conservative by another investor, or even too risky by a third party. However, a few general moderate allocation trends can be observed.

First, a moderate portfolio needs to include a significant portion of equities, perhaps higher than 50% of total assets. Second, a moderate allocation should target returns well above the expected future inflation rate, which limits exposure to cash and Treasury notes. Also, since moderate investors need to tolerate periodic market fluctuations, the investment time horizon should be at least 20 years to allow average equity returns to win the probability game.

Most asset managers define their moderate strategy as providing both capital appreciation and income, which is another way of saying they look to balance bond coupons, large dividend-paying equities and stocks with strong growth prospects.

The Aggressive Allocation Model

Aggressive asset allocations are the playground of the adventurous, the young and the ambitious investor. An extremely aggressive allocation would include small-cap equities, emerging markets stocks, exposure to leveraged investments, and probably some real estate investment trusts (REITs). Historically, such a portfolio would demonstrate large fluctuations in value from year to year. Research from QVMgroup suggests fully aggressive portfolios lose value nearly 20% of the time and show an annualized standard deviation of 18.07%.

Implicit in the aggressive mindset is a preference for growth and a diminished role for bonds, dividends or preservation of capital. Though inappropriate for older investors or those with income needs, there are statistical arguments for younger investors to favor moderately diverse and aggressive portfolios.

Stocks historically outperform bonds in the long run, and smaller stocks historically outperform larger stocks in the long run, although the latter difference is more negligible. Given these trends, a growth-focused portfolio is content to survive economic turbulence if it means a higher probability of greater returns over time.

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