What is Asset Allocation?
Asset allocation is an important part of any investment strategy, spreading the potential risks by saving into different types of assets.
Asset allocation is the process of dividing your savings into different types of investments, such as bonds, cash, shares and property. This diversifying of your portfolio helps you to minimize your risk.
How important is asset allocation?
If you want to sleep well at night without fretting about your investments potentially all shedding value at the same time, you need to make sure they’re adequately allocated.
The logic behind asset allocation is relatively simple. Not all types of investments react identically to the same event, so if you spread your investments you could reduce the risk and boost your chances of benefiting from all areas of the market.
Shares generally do well when people are confident and spending money, while bonds have a habit of outperforming when people are strapped for cash and interest rates are cut. Invest across asset classes and, in most circumstances, your portfolio should be equipped to handle all the customary setbacks that materialise during the course of business cycles.
What are asset classes?
An asset class is the name given to a category of investment with similar characteristics. There are four main asset classes:
- Cash: Put your money in a savings or current account, cash ISA or premium bond, and you can rest assured that it’s safe but also likely to erode in value as the price for goods and services rise.
- Fixed income: Loans made to a government or company and paid back with interest. Bonds offer regular income streams and, when everything goes according to plan, financial cushions during economic downturns.
- Property: Owning a slice of residential or commercial property, such as offices, shops and warehouses, and getting an income from the rent paid by tenants. These investments are usually cyclical, mirroring the health of the economy, and can lack liquidity.
- Shares: A slice of ownership in a company listed on the stock market. Shares historically outperform other major asset classes but are generally more prone to heavy losses.
Asset allocation is the proportion that you invest in each asset class. So, for example, if Wendy parked £3,000 in cash, £5,000 in bonds, £2,000 in property and £10,000 in shares, her total assets would be £20,000 and she’d have the following asset allocation:
- Cash: 15%
- Bonds: 25%
- Property: 10%
- Shares: 50%
How to get asset allocation right?
Asset allocation isn’t a standardised, one-size-fits-all kind of solution. Deciding how many eggs to put into each basket depends on your individual goals, time horizon and willingness to stomach losses in exchange for greater potential returns.
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If you are young and want to put something away for your retirement, you likely can afford to invest a larger proportion of your savings in shares. With plenty of time on your side, you could comfortably be able to ride out the market's ups and downs.
The same cannot be said of someone with a relatively short-term financial goal, such as saving up for a teenage child’s university education. In such cases, a more cautious asset allocation, consisting mainly of cash and bonds, could be a better strategy.
If you find the prospect of allocating your assets appropriately daunting, there’s help available. You could consider paying a financial adviser or robo adviser to assist you, or alternatively pick from a range of pre-built portfolios each packaged with multiple asset classes directly from a provider.
Remember, investments can rise and fall. You may get back less than you invest. Past performance is no guarantee of future results.
This is an informational guide and does not constitute advice. The content does not take into account personal, financial and tax circumstances of the reader. Before proceeding with any kind of investment, qualified professional advice should be sought.
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Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more