Asset allocation involves dividing an investment portfolio among different asset categories, such as equities, property, bonds and cash. The process of determining which mix of assets to hold in your portfolio at any given point in your life will depend largely on your time horizon and your ability to take and tolerate risk.
Your time horizon is the expected number of years you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a goal within 5 years would likely take on less risk because he or she has a shorter time horizon.
Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential 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 his or her original investment. In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
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Risk Versus Reward
When it comes to investing, risk and reward are inextricably entwined. You’ve probably heard the phrase “no pain, no gain” – those words come close to summing up the relationship between risk and reward. Don’t let anyone tell you otherwise: All investments involve some degree of risk. If you intend to purchase any investment – such as equities, property or bonds – it’s important that you understand before you invest that you could lose money.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you might expect to make more money by carefully investing in asset categories with greater risk, like equities or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for shortterm financial goals, yet you may expose yourself to other risks, such as interest rate or inflation risk that gradually erode the purchasing power of your money.
A vast array of investment products exist, with a varying degree of risk associated with them. These include:
For many financial goals, investing in a mix of asset classes can be a good strategy. Let’s take a closer look at the characteristics of the three major asset categories.
Equities – Equities have historically had the greatest risk and highest returns among the three major
asset categories. As an asset category, stocks are a portfolio’s “heavy hitter,” offering the greatest potential for growth. The volatility of stocks makes them a very risky investment in the short term.
Large company stocks as a group, for example, have lost money on average about one out of every three years. Sometimes the losses have been quite dramatic, however investors that have been willing to ride out the volatile returns of stocks over long periods of time have generally been rewarded with strong positive returns.
Bonds – Bonds are generally less volatile than stocks but offer more modest returns. As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor despite their lower potential for growth. You should keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.
Cash – Cash and cash equivalents – such as savings deposits, certificates of deposit, money market deposit accounts, and money market funds – are considered a safer investment, but offer the lowest return of the three major asset categories. The chances of losing money on an investment in this asset category are generally extremely low. The Government guarantees many investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do occur, but infrequently. 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.
Equities, bonds, and cash are the most common asset categories. These are the asset categories you would be likely to choose from when investing in a company pension plan. Other asset categories – including real estate, precious metals and other commodities and private equity also exist. Investors may include these asset categories within a portfolio, although they should first ensure they understand category-specific risks. This is part of our key role as investment managers.
Examples of asset allocation models for a defensive investor versus an aggressive investor are shown below:
You can see that the exposure to equities, especially, overseas equities that can be more volatile, are increased in the more aggressive portfolio, with less in bonds and property.
Risk Versus Reward in Action
Linking the previous sections together, we can look at some examples of the trade off in risk vs reward. If we use the two main investment asset classes of Bonds and Equities, we can look at the varying returns over the last decade and consider how different asset allocations have produced not just different returns, but also different levels of risk. In asset allocation, the decision on the amount of equities vs bonds in your portfolio is a very important decision. Simply buying stocks without regard of a possible bear (down) market can result in panic selling later. One’s true risk tolerance can be hard to gauge until having experienced a real down market with actual money invested. Finding the proper balance is key.
So, assuming we start with 80% in bonds and 20% in equities, then move 20% over to equities as we move up the risk scale, we can see the effect on actual returns over the past 10 years.
(Max Loss – Represents the worst running return over a period. E.g. The longest running consecutive loss without making a gain from 1st July 2004 to 30th June 2014, Source FE Analytics).
This shows, as you would hope, if you are willing and able to take on more risk, the rewards can be greater, but over the last ten years you will have had to have remained invested through some very turbulent times. This investment discipline is crucial to a long term investor and regular advice can help keep you on track.
Why Asset Allocation is so Important
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can try and mitigate against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Of course, there are exceptions to every rule and under significant moments of market stress (particularly event risks such as the recent credit crisis in 2007/08) many assets can move in the same direction – known as a positive correlation. Under more usual market conditions, circumstances that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and
your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.
If we again return to our previous asset allocation models of bonds and equities, we can look back over the last decade and review different moments in time when the market has been subject to particular event risks and review the correlation of the asset classes in action. Firstly, in 2000–2003 the market underwent a strong sell off after many years of strong returns, particularly in the technology sector. Companies with no actual profits were valued in their multi- millions and when realisation suddenly hit investors, a huge sell off ensued.
Under these market conditions bonds protected investors from the volatility of the equity markets and actually made money when equities were losing money (Tech Bubble – 1st January 2000 to 31st December 2003). This was not these case in more recent times when a credit crisis caused investors to consider even their cash deposits at risk and markets moved in unison.
You can see that even a portfolio invested in more defensive assets such as bonds can lose money in certain market conditions (Credit Crisis – 1st July 2007 to 31st March 2009). As a result, we do try and consider other alternative asset classes when building our portfolios to try and manage market volatility and increase portfolio diversification. There are two main types of asset allocation that we use and refer to in our literature:
Strategic Asset Allocation – the primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.
Tactical Asset Allocation – a shorter term view in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains, usually in line with a view on the current economic environment.
The Magic of Diversification
The practice of spreading money among different investments and asset classes to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns, without sacrificing too much potential gain.
In addition, asset allocation is important because it has a 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 goal. For example, if you are saving for a long-term goal such as retirement or university, most financial experts agree that you will probably need to include at least some equities or collective (pooled equity holdings) funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in equities or equity collective funds, for instance, would be inappropriate for a short-term goal, such as saving for a family’s summer holiday.
How to Get Started
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 you can live with. As you get closer to meeting your goal, you’ll need to be able to adjust the mix of assets.
If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. It is stated that determining your asset allocation is the most important decision that you’ll make with respect to your investments – that it’s even more important than the individual investments you buy.* With that in mind, you may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future.
(* Meir Statman, 1999–2000, 90% of the volatility of your portfolio is due to your asset allocation)
The Connection between Asset Allocation and Diversification
Diversification is a strategy that can be neatly summed up by the timeless adage “Don’t put all your eggs in one basket.” The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
Many investors use asset allocation as a way to diversify their investments among asset categories. But other investors deliberately do not. For example, investing entirely in equities, in the case of a twenty- five year-old investing for retirement, or investing entirely in cash equivalents, in the case of a family saving for the deposit on a house in the near future, might be reasonable asset allocation strategies under certain circumstances. But neither strategy attempts to reduce risk by holding different types of asset categories. So choosing an asset allocation model won’t necessarily diversify your portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments.
How to Diversify
A diversified portfolio should be diversified at two levels: between asset categories and also within asset categories. 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. The key is to identify investments in segments of each asset category that may perform differently under different market conditions. This is where specialist financial advice may prove useful.
Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of collective funds rather than through individual investments from each asset category. A collective fund is a company that pools money from many investors and therefore makes it easier for these investors to own a small portion of many investments. An index tracking stock market fund, for example a FTSE 100 tracker, owns stock in one hundred different companies.
A note of caution though. A collective investment fund doesn’t necessarily provide instant diversification, especially if the fund manager focuses on only one particular industry sector. If you invest in narrowly focused collective funds, you may need to invest in more than one collective fund to get the diversification you seek. Within asset categories, that may mean considering, for instance, large company stock funds as well as some small company and international stock funds. Between asset categories, that may mean considering equity funds, bond funds, property funds and money market funds. 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 upon the best way to diversify your portfolio.
Changing Your Asset Allocation
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you’ll likely need to change your asset allocation. Some refer to this as ‘lifestyling’. For example, some people investing for retirement hold less equities and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
It is also important to take into consideration the current outlook for the assets you are investing under – such as whether they are highly valued, less liquid or at risk from political intervention and changes in legislation.
It may not be necessary to completely change your asset allocation on the way towards your investment goals. Instead, you may wish to “rebalance” your portfolios.
The Connection between Asset Allocation and Diversification
Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may fall out of alignment with your investment goals. You’ll find that some of your investments will grow faster than others and by rebalancing, you’ll ensure that your portfolio does not overemphasise one or more asset categories. More importantly this will return your portfolio to an agreed / acceptable level of risk.
For example, let’s say you determined that stock investments should represent 60% of your portfolio. After a recent stock market increase, stock investments represent 80% of your portfolio. You’ll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to re-establish your original asset allocation mix.
When you rebalance, you’ll also need to review the investments within each asset allocation category. If any of these investments are out of alignment with your investment goals, you’ll need to make changes to bring them back to their original allocation within the asset category.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identify ways that you can manage these potential costs.