Investment Masterclass: Asset Allocation
Posted by: Philippa Gee
February 1st, 2008.
In our first investment masterclass we highlighted why investing makes sense and outlined some of the basic options available to today’s investor. In this article we take the next step and explore why holding a spread of assets makes sense, and why getting the balance right between them is a critical component of long-term investment success.
Look up ‘asset allocation’ in any dictionary and you’ll find a definition along the lines of “asset allocation is the division and allocation of a pool of funds between a range of asset classes”. In other words, if you have a pot of money to invest how should you invest it?
Most people tend to have a preferred asset class, most recently property being the favourite for many, but sometimes we all need to stand back and look at the balance of our portfolios.
Reaping real gains but avoiding the crunch
Whilst investment in assets such as shares provides scope to generate inflation-beating performance, it also involves taking on board varying degrees of risk. 2007’s credit crunch provided a stark reminder of the way in which investments can suffer, an event which is just the latest in a number of largely unpredictable factors that can impact on financial markets.
Such events re-emphasise the need to avoid placing all your investment eggs in one basket and diversifying risk across a different range of asset types. Why does this work? - Because over the medium to long-term, different assets behave in different ways.
Pinning the tail on the investment donkey
In addition it’s an equally challenging task to predict which asset class or geographic area is likely to outperform from here. This chart starkly illustrates this by ranking the best to worst performing assets over the last 18 years – its patchwork nature demonstrating the difficulties of picking the best single investment option. Again the solution is diversification.
Get the balance right
But getting the right blend between assets involves more than a random selection and requires a careful assessment of their respective characteristics, behaviours and interrelationships. It is important to get this stage right because research has shown how asset allocation ‘has been proved to determine the majority (up to 90%) of the variation in returns between different portfolios over the long-term.’ In other words – getting the balance right between different asset classes is key.
What’s going to work? – Teamwork!
Think of your portfolio like a football team and you’ll be on the right lines. Some asset classes – like cash and bonds - have more ‘defensive’ characteristics, whilst equities and their higher return potential can provide your portfolio with a real attacking threat. Like any successful team you should look to have ‘balance’, providing scope for out-performance home and away, whatever the prevailing financial backdrop.
Assessing risk & being mindful of time…
When creating a portfolio it is crucial to understand the amount of risk you are willing to take as this will determine the best type of asset mix, and ultimately the potential investment rewards they can expect to generate. Time horizon is also important – if for example you are saving for retirement, the closer you get to your goal the less risk you are likely to want to be exposed to! You don’t want your lump-sum fluctuating wildly just before retirement.
From tactics board to pitch
The rationale for diversifying your portfolio between different asset classes is a relatively straightforward concept to grasp. Implementing it into practice and achieving effective ‘asset allocation’ is more complex. There’s no real reason why private individuals can’t create their own portfolios but doing so can become time consuming and expensive. Fortunately there are a number of solutions available. An Independent Financial Adviser can help you construct a balanced portfolio aligned with your needs and there are an increasing number of ready made and professionally managed ‘portfolios’ for investors to choose from – many of which directly reflect on an individual’s attitude to risk.
For a free copy of our Investments Guide call 0800 294 7221 or download the guide now.
This entry was posted on Friday, February 1st, 2008 at 10:00 am and is filed under Investments.
Listen to this article as a podcast
