As aforementioned in previous articles, backing one horse with all your available cash is not a creed successful investors will traditionally follow. Optimising investment allocation across asset classes is critical to maximising your returns whilst simultaneously not exceeding desired levels of risk.
In the simplest terms, asset allocation is the process of dividing an investment portfolio among different asset categories, such as equities, bonds, and commodities. The right asset allocation for you is dependent on your financial goals, risk tolerance, and investment time horizon. Some general guidelines are below:
1. Determine your financial goals; what do you want to achieve with your investments? Are you saving for retirement or planning a large purchase (like a house)?
2. Assess your risk tolerance; how comfortable are you with the ups and downs of the stock market and the possibility of losing some of your money?
3. Consider your time horizon; how long do you have to reach your financial goals?
Once you have evaluated what general investment direction might suit your timelines and tolerances, you will need to make sure you are diversifying your portfolio to suit your personal goals.
Diversifying your allocation means spreading your investments across different asset classes. This will reduce your risk as all your cash is not backing just one horse.
For example, if you only invest in one stock and that stock performs poorly, your entire investment portfolio will be impacted. If you diversify and invest in a mix of equities, bonds, and other assets, the impact of any single investment performing poorly is lessened. Diversification helps to smooth out the ups and downs of the market and reduces the overall volatility of your portfolio.
Moreover, diversification could increase your overall returns over the long-term by allowing you to invest in a wider range of assets that may perform differently at different times.
The emergence of ETFs, which bucket certain types of investments (often into their respective risk profiles), has made diversification easier again. By purchasing one unit of an ETF you are automatically diversified across several instruments.
Your risk profile refers to the tolerance for investment risk and the degree of volatility you are willing to accept.
Regardless of your risk tolerance, you may be investing in similar assets, but the size of the allocation will be different. You can bring your overall risk down by allocating a larger portion of your portfolio to typically less volatile assets, such as bonds and cash. On the other hand, asset classes like equities and crypto currencies, which typically experience larger price moves, can increase your risk.
It is important to remember that higher risk investments generally have the potential for higher returns, but also come with a higher chance of loss. The key is to find the right balance between risk and reward that fits with your financial goals.
Most investors, especially if you are working with a wealth manager, will evaluate your risk tolerance, timelines and goals, to subsequently place you into an “investor type” that will help guide your choice of portfolio.
A useful way individuals can get started when they are first deciding on how to allocate their assets is by comparing them to model portfolios with a similar risk profile.
this investor has a lower tolerance for risk and is more concerned with preserving their capital than maximizing returns. This type of investor might allocate a higher portion of their portfolio to bonds, and a smaller portion to higher-risk assets, such as equity. This allocation provides a good balance between stability and potential for growth, while reducing the overall risk in the portfolio. In addition, it is also more likely generate regular streams of income.
balanced investors often seek a mix of stability and growth whilst being willing to accept a moderate level of risk. This type of investor might allocate a portion of their portfolio to both fixed-income assets, such as bonds, and growth-oriented assets, such as equity. Real estate is another asset class that will bring the risk profile of a portfolio down and typically can be used to hedge inflation. This mix of assets also provides diversification, while still offering some protection against market volatility.
return maximisers who accept higher levels of risk. This type of investor might allocate a higher portion of their portfolio to equities and cryptocurrencies, and less to bonds and cash. This allocation allows the investor to take advantage of the growth potential of stocks, while still having some exposure to less volatile fixed-income assets.
Whilst these are three very general buckets to put investors into, they serve as a good starting point for those who are uncertain of how they want to initially allocate their assets.
To find your risk appetite, take this quick test here.
It is important to note that there are also different levels of risk within each asset class. Equities for example, consist of growth or value stocks, which typically experience varying price fluctuations.
Certain sectors within asset classes bear more risk than others too, as can be seen with the latest onslaught to major US tech equities, whilst US energy equities have remained steady and, in many cases, seen gains (as of Feb 2023).
Countries of issuing are an important factor to take into consideration for fixed income, as whilst US Treasury bonds are seen as one of the lowest risk investments, there are other sovereign bonds for certain countries that will carry more risk of default with them (but as a result offer higher returns).
Again, we can see that the more detail an investor digs into when allocating their assets, the better positioned they will be to decide where exactly they want to put their money.
The old rule of thumb was to subtract your age from 100 (nowadays people say 110 or 120 because of increased life expectancy) and that number is the % you should allocate to stocks. In truth, it also depends on your risk tolerance, and you need to factor that into any asset allocation decisions. That said, this Investopedia article helps gives some guidance on asset allocation based on your age bracket.
In closing, the importance of allocating assets efficiently and monitoring this over time is a key to achieving investment goals. The allocation preferences can be fluid and could change at different times in someone’s life, depending on factors such as time horizons and risk tolerance. Rather than betting it all on just one horse., using the profiles above will allow investors to be in the best possible position to decide where they should allocate their money.
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