Understanding
asset allocation

Asset allocation is one of the fundamental tenets to investing wisely, and hopefully successfully. Read more in this guide.

The most familiar asset classes are the traditional ones: equities (shares), fixed income (bonds) and cash. Alternatives, meanwhile, encompass everything from investment strategies such as hedge funds and private equity to hard commodities such as gold, soft commodities such as corn, complex financial instruments, collectibles and art. As you might expect, these asset classes tend to behave differently in terms of their volatility and when in the economic cycle they tend to rise and fall in value. Assets which tend to move in opposite directions are said to be “uncorrelated”.

Asset allocation is an investment strategy that aims to strike a careful balance between risk and reward by leveraging the fluctuating risks associated with different asset classes. An asset allocation strategy takes account of your financial goals, risk tolerance and investment horizon (this is particularly important), and then develops a strategy to divide your investments between assets classes (and sub-classes of them) in a way that serves these different priorities.

How it works

Different types of assets are associated with different levels of risk and, correspondingly, achieve different levels of return. Fixed income investments, also known as bonds, provide a steady, pre-planned income stream and typically, unless there is a default, you will not lose your principal investment. This makes fixed income a relatively low-risk investment. However, not all fixed income investments are created equal: at one end of the risk spectrum are government bonds issued by strong economies, followed by debt issued by the highest-quality, financially strong companies; at the other are “junk” or high-yield bonds, where the issuer is considered high risk. (There are several large ratings agencies which assess the debt of bond issuers and you should remember that each has a slightly rating system.)

Equities, or shares, on the other hand, fluctuate in price on an intraday basis (price swings over time are known as volatility) and carry a higher degree of investment risk than fixed income. However, as a payoff, equity investors are typically rewarded with superior returns. The weighting of equities to fixed income in your portfolio will depend on a range of factors: if you are very risk averse, your wealth manager may allocate more of your assets to fixed income, and less to equities. If you are more concerned with increasing your wealth, and are willing to accept risk, you may choose to invest more heavily in equities, or in a variety of other investments which are considered riskier and potentially more rewarding.

Your investment time horizon is also an important consideration your wealth manager will discuss with you. If you are investing for a far-off goal then you could be able to afford to take on more investment risk since you have more time to recover from any potential losses, for instance. Your personal goals should determine your individual asset allocation strategy.

Summary

This is a very simplified example of asset allocation. Your wealth manager will likely want to include proportions of a wide variety of assets in your portfolio, probably representing many sectors and geographic locations. As these assets react differently to changes in the economic outlook, one of the key aspects of asset allocation is to change their proportions in response to shifts in the market. A well-diversified portfolio can minimise risk significantly. Yet asset allocation is also about trying to capture additional returns. For example, if analysts foresee an upswing in the equity markets then your wealth manager may want to make a tactical call to increase the percentage of your portfolio allocated to stocks.

A further important element of asset allocation is the need for your wealth manager to periodically rebalance your portfolio back to the strategic asset allocation which was devised for you. Over time, the value of all the different assets in your portfolio will rise or fall in line with markets. Therefore they will come to represent different proportions to the original asset allocation and so will have to be brought back into line. This is also an opportunity to re-analyse whether your investments are still aligned with your goals. These, of course, are subject to change over life’s journey.

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