What Is Asset Allocation and Why is it Important?
“Ten grand has been wiped from my pension!!!”
That was the panicked cry of a friend who had checked his pension at the start of the COVID-19 outbreak.
Concerned over whether prices were going to plummet further, he was looking to take action.
I suggested he do nothing – he couldn’t have anyway with pensions locked away until age 55.
With decades before his retirement, I assured him his pension would recover. Stock markets bounced back just days later.
Thankfully, my friend didn’t/couldn’t sell during the crash.
But some investors weren’t as fortunate. Emotions got the better of them, and they sold out at exactly the wrong time. Their losses are now crystallised.
If their portfolio wasn’t as volatile, they might have remained invested and came out the other side unscathed.
Knowing your risk tolerance and building a portfolio with the right mix of assets that allows you to ride out the storms is crucial for long-term investing success.
In today’s post, we’re going to look at what asset allocation is, why it matters, and how to determine yours.
What Is Asset Allocation?
Despite sounding all fancy pants, asset allocation simply refers to how much you hold of each type of investment.
Most investors will have a portfolio made up of stocks, property, bonds, and cash.
Each asset class has its own characteristics.
Some rise and fall in value wildly (known as volatility), and others will be more stable. Some will have strong cashflow, whereas their capital appreciation prospects are low. And… you get the idea…
If you’re purposeful about the weighting (or percentage) of each asset you hold, you can control how your portfolio is likely to perform in varying market conditions.
Why Is Asset Allocation Important?
You’re probably getting the feeling that asset allocation is something you should care about.
If you still don’t see what all the fuss is about, here are three reasons why getting the right mix of assets is essential:
Wise investors don’t have all their eggs in one basket.
They reduce their risk of any singular company, market or asset underperforming – or even wiping out all their capital – by spreading their money across multiple investments.
Different assets have markets that move separately from one another – for example; if shares rise in value, bonds tend to fall (and vice versa).
Holding a diversified portfolio of uncorrelated assets reduces your singular investment risk and allows you to hedge your bets – if one or two asset classes aren’t doing well, the others might be.
2. Balances Your Risk Vs Return
Property and shares are riskier assets that have markets more likely to crash, but they also provide the greatest return.
Fixed income deposits – such as bonds and fixed-term savings accounts – are less risky and their value doesn’t fluctuate, but their return is lower.
Generally, the higher the risk, the greater the return.
Holding both high-risk, high-return assets and slow-to-no growth but stable assets allows you to balance your need for a return with your appetite for risk.
3. Smooths Volatility
If your portfolio is made up entirely of shares, you’re in for a wild ride.
To lessen the highs and lows, it’s wise to hold some bonds and cash.
A balanced portfolio won’t swing in value as wildly, which could stop you from losing your nerve during a market downturn.
What Asset Allocation Should I have?
So, now you know the importance of asset allocation, how do you decide yours?
The make-up of your portfolio should consider your age, goals, and risk tolerance.
If you’re young with a long investing time horizon, you’re better off holding more high-risk, high-return assets as you’ll end up with a bigger pot.
And as you get closer to the point of retirement, reduce the number of high-risk investments you hold in favour of bonds.
A good rule of thumb to determine your exposure to higher risk assets is to take your age away from 100.
Using this formula, a 35-year-old would have 65% of their portfolio in high-risk, high-growth assets.
100 – 35 (age) = 65 (% in higher risk assets)
Sample Portfolio: 55% shares, 10% property, 35% bonds
However, this formula doesn’t take account of your risk profile and how you react to market crashes.
If you’re a highly risk-averse person that would be freaked out by a 20% drop in the value of your portfolio, you may want to hold more bonds to “smooth out” the volatility.
It’s worth sitting an online risk profile questionnaire (Google them, there’s many) to find out your risk tolerance and tweaking your asset allocation to suit.
Cautious Investors Beware
The asset allocation formula is a good starting point, but there’s a danger that you leave investing returns on the table by being overly cautious (especially if you’re young).
If you’re in your 20’s and 30’s, you should consider going all-in on shares and other investments with high growth potential.
You have at least three decades until retirement, allowing you plenty of time to recover from any major losses or market crashes.
If it helps, set up a standing order to invest in a Stocks and Shares ISA automatically, and only check the balance once a year.
Regular Investing, working in partnership with its best mate, Compound Interest, will make you incredibly wealthy over the course of your career.
Wrapping It Up
Investors often overlook asset allocation… until something like a global pandemic highlights how important it is.
Having the right asset allocation for your risk tolerance and personal circumstances will make your investing journey much smoother.
If you’re still struggling to decide what mix of investments is right for you, try an online asset allocation calculator.
Once you’ve decided on your mix, you’ll have to rejig your portfolio every year or so to remain within your target weightings.
The make-up of your portfolio will also change the closer you get to retirement.
If that sounds like too much work, then consider a fund that automatically rebalances your share and bond holdings as you near retirement, such as the Vanguard Target Retirement Fund.
But whatever you do, don’t ignore asset allocation.
Doing so could lead to making poor decisions next time the world seems like it’s about to end.