Guide to asset allocation
Asset allocation involves dividing an investment portfolio among different asset categories, such as equities, bonds, and cash. The process of determining which mix of assets to hold in your portfolio will depend on a variety of different factors including age, time horizon and risk tolerance.
Age and time horizon
Your age and your time horizon are linked in terms of investment choices. Your time horizon may be limited to months or decades but you should have a firm idea as to what you are trying to achieve as part of your financial goal. A younger investor with a longer time horizon may feel more comfortable taking on a riskier or more volatile investment because they can look beyond the immediate periods of slow economic growth and the inevitable ups and downs of stock markets. Conversely, an investor coming up to retirement would probably take on less risk because they have a shorter time horizon and want to avoid the potential short-term market moves.
Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns over time. When it comes to investing, risk and reward are inextricably linked. All investments involve some degree of risk and you should make sure you understand these fully before investing, if in any doubt, you should seek financial advice. The reward for taking on this risk is the potential for a greater investment returns. An aggressive investor, or one with a high risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low risk tolerance, tends to favour investments that will preserve their original investment.
There are a vast array of investment products; equities, bonds, funds and cash are only the tip of the iceberg. Within these asset classes there are many sub groups and even derivatives of these groups and sub groups. However it is essential to understand the basics of equities, bonds, and cash before thinking about anything more complex. These three asset classes have some basic characteristics;
Or stocks as they are also known have, historically, had the greatest risk and highest returns among the three major asset categories. As an asset class, equities offer the greatest potential for capital growth. However, the volatility of equities can make them a very risky investment in the short term, but investors who are able to ride out the volatile returns of stocks over long periods of time generally have been rewarded with strong positive returns., In the UK, over the past 50 years the real (adjusted for inflation) annualised returns from equities is 5.5%. However, you should remember that past performance is not a guide to future performance.
Government Bonds, or Gilts as they are called in the UK, are generally less volatile than equities but offer more modest returns. As a result, an investor approaching a financial goal or retirement age might increase their bond holdings relative to their equity holdings, because the reduced risk of holding more bonds would be attractive to the investor despite the lower growth potential. There are other types of bonds that are linked to corporate debt and these can offer higher returns than government debt, but the associated risk is usually higher. UK Gilts over the past 50 years have had an annualised real return of 2.5%.
And cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time. Over the past 50 years, in the UK, cash would have returned 1.5% on a real annualised basis.
Equities, bonds, and cash are the most common asset categories, although some investors might also look at property, private equity or commodities. Investments in these asset categories will result in a degree of investment risk. Before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.
Why asset allocation is so important
By including different asset classes in a portfolio, investment returns will move up and down depending on the varying market conditions. Many investors use asset allocation as a way to diversify their investments. Diversification is best described as not putting all your eggs in one basket, so that by spreading your money among various investments not all of them will go up or down at the same time. So, by investing in more than one asset category, you'll spread your risk making your portfolio's overall investment returns less volatile.
In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your target. For example, if you have 40 or 50 years until you retire, then most financial experts agree that you should have some exposure to equities in your portfolio. On the other hand, a portfolio heavily weighted to equities may be inappropriate if you are only five years from retirement.
Determining the appropriate asset allocation model for a financial goal is a complicated task. Basically, you're trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk with which you feel comfortable. Also, as you get closer to meeting your goal, you'll need to consider adjusting the mix of assets.
Many believe that determining your asset allocation is the most important decision you'll make with respect to your investments, even more important than the individual investments you buy.
A diversified portfolio should be diversified at two levels: between asset classes and within asset classes. So, in addition to allocating your investments among equities, bonds, cash equivalents, and possibly other asset categories, you'll also need to spread out your investments within each asset category. One way to diversify your investments within an asset class is to identify and invest in a wide range of companies in different industry sectors.
Diversification can be challenging; some investors may find it easier to diversify within each asset category through the ownership of investment funds rather than through individual investments from each asset category. For example, an Investment Trust is a company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. Investment Trusts make it easy for investors to own a small portion of many investments. A typical fund may own over 100 different investments. Again it is important to understand that the objective of a fund is aligned to your own investment goals.
Be aware however, that a fund may not necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. Of course, as you add more investments to your portfolio, you'll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you'll need to consider these costs when deciding the best way to diversify your portfolio.
Having more investment choices is good, however it does make the decision making process more complicated. It’s important to understand the implications of your investment decisions before you implement your choices.
You should be fully aware of the risks you are taking in allocating your assets. If at all in doubt you should consult a financial advisor.