Asset Allocation

When creating financial plans to achieve specific goals, understanding the different approaches to managing investments is essential. In essence, asset allocation is central to building an efficient portfolio, as it helps distribute resources across categories to balance risk and return effectively. 

What is meant by asset allocation? 

Asset allocation is the practice of distributing investments across various asset classes, such as equities, fixed income, real estate and commodities, to align with your financial objectives and risk profile. It involves determining the proportion of each asset class in your portfolio, ensuring a balanced approach to managing potential returns and risks. 

Importance of asset allocation  

Here’s why asset allocation is important: 

• It spreads your investments across different asset classes, reducing the risk of loss by balancing poor performance in one asset with gains in others.  
• A well-planned allocation can boost returns, as it aligns with your financial goals and risk tolerance.  
• It ensures that your portfolio meets both short-term and long-term objectives by aligning with your risk profile and investment horizon.  
• Asset allocation helps prevent emotional reactions to market highs and lows, promoting disciplined investing.  
• It provides flexibility to adjust your portfolio based on market changes, allowing you to take advantage of opportunities.  
• Balancing different asset classes offers stability, helping your portfolio grow steadily despite market fluctuations.  

How does asset allocation work? 

Asset allocation is calculated by dividing your investments among different asset classes. Here’s the process: 

Assess risk tolerance 

Determine how much risk you are comfortable with. If you have a high-risk tolerance, you might allocate more to equities. Prudent investors typically allocate more to safer assets like bonds or fixed income. 

Define financial goals 

Depending on whether your goals are short-term (e.g., buying a car) or long-term (e.g., retirement), your asset mix will differ. Long-term goals usually involve more equities, while short-term ones favour stable, lower-risk assets. 

Set time horizon 

Your investment timeline affects your allocation. A longer time horizon allows for a higher allocation to riskier assets like equities. Short-term investments often lean toward safer, more liquid assets. 

Use tools for guidance  

Many investors use asset allocation calculators to get a personalised asset mix based on their age, risk level, and investment period. For example, the 100-minus-age rule suggests putting a percentage in equities equal to 100 minus your age, with the rest in safer assets. 

Rebalancing periodically is essential to maintain your preferred asset allocation as market conditions and personal circumstances evolve. 

Asset allocation strategies 

Age-based asset allocation 

This strategy follows the "100 minus age" rule. It suggests allocating a percentage of your portfolio to equities by subtracting your age from 100. For example, if you're 30 years old, 70% of your portfolio could be in equities, with the remaining 30% in safer assets like bonds or fixed income. As you age, your allocation to equities decreases, reducing risk and focusing on stability as you approach retirement. 

Lifecycle asset allocation 

Lifecycle or target-date funds automatically adjust the asset allocation as you age. Early in your career, these asset allocation funds are weighted more towards equities for growth potential. As you near retirement, they gradually shift towards bonds or other safer assets, ensuring a more conservative allocation to protect your savings.   

Tactical asset allocation 

This strategy allows for short-term deviations from the set allocation to take advantage of market opportunities. For example, if equities are expected to perform better in the near future, you might temporarily increase your equity allocation. This strategy is dynamic and requires market expertise to time the shifts effectively. 

Dynamic asset allocation 

In this strategy, the asset mix continuously adjusts based on market conditions. It aims to buy low and sell high, increasing exposure to equities when valuations are low and reducing it when markets are high. This approach is more active and suitable for investors who monitor market trends closely. 

There is another better way of reducing the dependency on asset allocation and that is through the use of multi-asset funds. These funds take responsibility for diversification by investing in a variety of securities, including stocks, bonds and precious metals, and adjusting to the prevailing market conditions. For investors who wish to avoid frequent tinkering with their investments, multi-asset funds act as a smooth means of managing a diversified portfolio that is always optimising the investor’s investments.