What is asset allocation?

Written by Daily Fix - Published 08-Aug-2022, last updated 03-Jan-2024

Asset allocation is the process of dividing an investor's assets among different investment vehicles to achieve a desired risk and return profile. Asset allocation is one of the most important decisions an investor makes, because it determines how much risk they are taking on and how much potential return they could earn.

What are the different types of asset classes?

The three main asset classes are stocks, bonds, and cash. Within each class there are many different types of investments, each with its own risks and returns. Anyone with a pension is likely to have exposure to these tree asset classes.

But there are other asset classes too - including property, precious metals (especially gold) and currencies.

What are 'alternative assets'?

Alternatives assets can loosely be described as assets excluding stack, bonds and cash.

Investopedia describes Alternative Investments as:

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash.

Is Bitcoin an alternative asset?

Bitcoin and other cryptocurrencies can be thought of as alternative assets.

What are other examples of alternative assets?

Other alternative assets include art, wine, classic cars and luxury watches.

How to determine your asset allocation?

There's no "correct" answer to this question.

Investment allocations are impacted by how much time you have to invest, how much growth you need to achieve for your financial goals and the amount of risk you're comfortable with to obtain that growth.

Your assets should be commensurate with how far you are willing to lose in times of a market crash.

If you have trouble deciding how to build your portfolio and allocate your assets, you don't have to make all the decisions on your own; a financial adviser can help you turn your goals and broader personal financial situation into holistic investment decisions tailored just for you and your circumstances.

Alternatively, automated advising platforms provide ready-made portfolios based on investors' targeted preferences and the answers the investor provides to a series of questions posed by the 'roboadvisor'.

What is diversification?

Diversification is the "process of allocating capital in a way that reduces the exposure to any one particular asset or risk."

Diversification can be achieved by reducing risk or volatility investing in a variety of asset classes, and further by investing in a variety of different assets within each asset class.

But what does that even mean!

If you put all of your money into the shares of one company and that company ceased trading you would probably lose everything. Investing in just one company is NOT diversified investing.

If, instead, you spread your money across the shares of two different companies and one of them ceased trading you would only lose half of your money because you "diversified" your investments. Albeit in the most simplified form.

But if both of the companies you chose to invest in were in the same industry and that insustry as a whole saw a downturn then both of your investments would be likely to fall in value - so although you split your investment between two different companies they were "highly correlated" so their value generally moves in the same direction.

What is high correlation?

If investments are described as highly correlated then their prices tend to rise or fall in tandem. For example, shares in industries that are closely related.

What is low correlation

Low correlation means there is very little or no relation to each other. So a downturn in one of the investments doesn't necessarily mean there will be a downturn in the other investment.

What is negative correlation

Negative correlation means that investments move in opposite ways to each other. Gold, for instance, often increases in price whilst share markets fall. They are negatively correlated.

How do you diversify your investments?

Spread your investments across a range of assets

One way to diversify is to choose a range of assets. For example, a mix of shares, bonds, fixed interest securities and cash.

Diversify by sector

Look to purchase assets in different sectors. For example, rather that putting all of your money into bank shares, spread the money across a variety of sectors such as banking, consumer staples, healthcare, infrastructure and technology. That way, if one sectors sees a downturn and the others fair well, your overall portfolio is diversified.

Spread your investments across the world

If all of your share portfolio is invested in the shares of businesses trading mostly in one country and that country experienced a resession, then your whole portfolio could be impacted.

By spreading your money and Investing in different regions and countries this can reduce the impact of stock market movements in one particular country so that you're not just affected by the economic conditions of one country and one government's economic policies - your portfolio is diversified across the world.

How to rebalance your portfolio

Over time, the asset allocation you have put in place is likely to be altered by some sectors or asset classes doing well and others seeing a decline. This means that your allocations are no longer in line with your preferred asset allocation and it's time to rebalance.

Rebalancing is the act of brining your asset allocation back to your chosen percentages. But you may also change your preferred asses split if there is a change in your risk tolerence, financial goals or financial situation.

If you originally spread your investments across world equities for instance, and one market has done particularly well, your portfolio may now hold a greater percentage in that market than you originally chose so you could "rebalance" by moving some funds from the outperforming market to other allocations within your portfolio.

Another common reason for changing your asset allocation and wanting to rebalance your investments is a change in your time horizon. For example, many people investing for retirement move to holding less in equities and more in bonds and cash as they get closer to retirement age. This could be because they want to reduce risk.

Conclusion

In conclusion, asset allocation is important to consider when investing, whether you are saving for retirement or you have other goals. By determining your risk tolerance and investment goals, you can create a portfolio that is right for you. Review your asset allocation on a regular basis to ensure that it still aligns with your goals. And finally, don't forget to rebalance your portfolio as needed!

This article is written for educational purposes only and to spark interest in order that you go and do your own research. It does not constitute financial or investment advice.