Asset allocation: a guide for beginners
When it comes to investing, the old adage ‘never put all of your eggs in one basket’ is worth remembering. Investing in a wide range of assets and asset classes can help you create a diverse portfolio while balancing risk. Exactly how you allocate your assets will depend on various factors including your age, personal circumstances, financial goals and appetite for risk.
In this article, we explain exactly what asset allocation is and why it’s important. We also look at the different types of asset classes (including cash assets like savings accounts) and outline some common asset allocation strategies you might wish to consider.
- Definition: Asset allocation is the process of dividing capital between different asset classes including cash, equities, bonds and property
- Balancing risk: Investing in a mix of asset classes enables you to build a diverse portfolio that mitigates risk while helping you to achieve your financial goals
- Age: Many asset allocation models take age into account and reduce the share of your investments in riskier asset classes as you get closer to retirement
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What are considered assets?
In simple terms, an asset is anything you own that has financial value or can be converted into cash. Individuals, companies and governments all own assets, but for the purpose of this article we’re only focusing on personal assets.
From cash to equities, there are various types of personal assets and asset classes. Some of the main categories are summarised below:
- Cash – This includes physical cash (and cash equivalents) and money you have in a bank account or savings account(s). Savings held in easy access accounts, notice accounts, fixed rate bonds and ISAs are all considered cash assets. Cash asset growth is dependent on interest rates and can be eroded by inflation.
- Property and land – This could be your own home, a buy-to-let property or a piece of land. Alternatively, you might have shares in a property company or a property portfolio. Generally speaking, property assets appreciate over time as house prices rise.
- Equities – Equities refer to shares you’ve purchased in a company that’s listed on the stock market. Owning stocks entitles you to a portion of the profits and assets the company makes. Once you own shares in a company, you can trade them on the stock exchange. Although equities can often be a strong source of growth, they can also be high risk.
- Bonds – Bonds are a bit like an IOU. When you buy bonds, you’re effectively lending money to an institution, such as the government or a company. The organisation must then pay back the loan with interest.
- Peer-to-peer loans – Peer-to-peer lending is when you invest your money into a business or project that needs capital to grow. Your investment is paid back to you with interest, provided that the business or project has succeeded.
- Commodities – Commodities cover a wide range of materials including precious metals like gold, grains and other foodstuff, and oil. Commodity prices rise and fall in line with demand.
- Alternative investments – This category tends to cover any type of asset that’s not listed above. Valuable items like fine wine, art, antiques, classic cars, jewellery and cryptocurrency are all examples of alternative investments.
What is asset allocation?
Asset allocation is the process of apportioning your money between different asset classes to create a diverse investment portfolio that works for you. This often means investing in a combination of high-risk and low-risk asset types. The idea behind this is that even if one type of asset falls in value, another may be performing well (thereby helping to offset potential losses).
Although this might sound simple enough, it can be quite difficult to know exactly where to allocate assets to achieve your desired outcome. Asset allocation is a very personal process as everyone has different priorities and tolerance for risk.
As we explain later, time also plays a factor. How you choose to allocate assets in your twenties, for example, may be different to how you approach the matter in your fifties when retirement is imminent and there’s less time to recover from heavy losses.
Why is asset allocation important?
Asset allocation is important to investing because it can help to reduce risk while still allowing you to grow your wealth. The global financial crisis in 2008 is a particularly good example of why having an asset allocation strategy matters.
When the stock market crashed, equities suffered huge losses. Bonds, on the other hand, increased in value. Building a diverse portfolio that includes a mix of both bonds and equities can therefore be a good way to balance risk and shelter your capital from the volatility of the stock market.
What are the different types of asset allocation?
There are various asset allocation strategies you can employ, but the three main types are strategic asset allocation, tactical asset allocation and dynamic asset allocation. Whichever asset allocation model you choose, it should include a mix of assets that reflect your personal financial goals, appetite for risk and investment timescales.
Strategic asset allocation
Strategic asset allocation means that you set target allocations for different asset classes to help you achieve your specific investment aims. Investors then rebalance their portfolio periodically to ensure it’s still meeting their desired target mix.
Often likened to a buy-and-hold stocks strategy, strategic asset allocation encourages you to take a disciplined approach to managing your portfolio. It also reduces the chances of you making impulse decisions out of fear or greed.
Tactical asset allocation
Although similar to strategic asset allocation, tactical asset allocation tends to be more flexible because it allows you to respond to market conditions. Taking a moderately active approach means you can change the weighting of assets in particular classes to take advantage of short-term economic changes.
Once the desired outcome is achieved, most people will usually revert to the original asset mix. Tactical asset allocation requires specialist investment knowledge and a good understanding of market timing.
Dynamic asset allocation
Dynamic asset allocation is an active management strategy in which a fund manager continuously adjusts the mix of asset classes in response to changes in the economy or stock market. This model typically involves increasing the percentage of assets in classes that are performing well and reducing the weight of assets in classes that are underperforming.
What is an asset allocation fund?
An asset allocation fund is a diversified portfolio of investments that covers a broad range of asset classes. The allocation of each asset can either be a fixed percentage or a variable percentage that changes to reflect market conditions.
Asset allocation funds allow investors to balance risk and achieve the best possible returns from a mix of asset classes like bonds, stocks and cash equivalents. To achieve maximum diversification, assets within individual classes may also be spread across different countries and industries.
Age-based asset allocation
Age is an important factor to consider when you’re deciding how to allocate your assets. That’s because most of us can tolerate less risk as we get older. You might be willing to take on more risk in your twenties and thirties because your investments should have time to recover from any losses before you retire. If you’re in your fifties, however, it’s important to protect your nest egg from significant financial losses – take on too much risk at this stage and your capital may not be able to bounce back before you retire.
As a rule of thumb, an age-based asset allocation strategy usually means holding a percentage of stocks that’s equal to 100 minus your age. If you’re 45, for example, following this model means 55% of your portfolio should be made up of stock assets. However, with average life expectancy rising, some experts believe it may be better to adjust this rule to 110 minus your age.
Once you’ve retired, or if you’d simply prefer to take a more cautious approach to investing, it might be worth putting a significant portion of your money into a long-term savings account like a fixed rate bond.
These types of savings accounts require you to lock your money away for a set period – typically one year, two years, three years, five years or six months. In return, you’ll earn a guaranteed, fixed interest rate that’s usually higher than that available on other types of savings accounts. This means fixed rate bonds can be a good option if you want to enjoy strong growth without putting your capital at risk.
Asset allocation based on life-cycle funds
Also known as target-based funds, life-cycle funds are automatically adjusted to suit the investor’s risk tolerance as a particular life event or target date (e.g. retirement) approaches.
In practice, this usually means the percentage of assets you hold in higher-risk asset classes like equities is reduced as you approach retirement, while your share of assets in lower-risk classes like bonds increases. In this way, life-cycle funds follow the age-based asset allocation strategy outlined above.
Life-cycle funds work on the belief that younger investors can tolerate more risk. However, it’s important to note that this is a general assumption and this approach may not work for everyone. A financial adviser or fund manager can help you determine the best asset allocation model for your particular needs.
How to achieve optimal asset allocation
How you achieve optimal asset allocation depends on various factors including your age, attitude to risk, financial circumstances and investment objectives. Asset allocation is a very personal process and what’s right for you may not be suitable for someone else.
The following tips can help you build an optimal portfolio that achieves your financial goals while mitigating unnecessary risk.
1. Adjust your asset allocation strategy to suit your age
As we’ve already explained, reviewing and adjusting your asset allocation as you get older can be a good way to achieve maximum growth while balancing risk. This usually means putting a greater share of your assets into riskier investments like stocks when you’re younger (the idea being that you’ll have time to ride out any market turbulence).
As you get older and nearer retirement, you can then reduce the percentage of capital you hold in high-risk investments and increase the share you have in lower-risk asset classes like bonds.
2. Be honest about your appetite for risk
Although most asset allocation models work on the assumption that younger people can tolerate more risk (see above), this isn’t always the case. If you’re a younger investor and the prospect of investing a large share of your capital in the stock market fills you with dread, it might be wise to take a more cautious approach. You may not see quite the same level of growth over the long term, but at least you’ll be able to sleep at night.
3. Don’t allow short-term market conditions to dictate your asset allocation strategy
Although it can be tempting to let current market conditions influence your asset allocation strategy, this is a risky move. It’s usually better to sit tight rather than make knee-jerk decisions in response to short-term market events.
After all, achieving optimal asset allocation is a marathon, not a sprint. Instead, you might want to consider following a tactical asset allocation strategy (see earlier) that allows you to rebalance your portfolio at regular intervals.
4. Diversify your assets within each asset class
To achieve optimal asset allocation, it’s usually wise to have a diverse portfolio that contains a mix of asset classes such as equities/ stocks, bonds, cash and property. You might also want to think about diversifying within each individual asset class.
Depending on the type of asset, this might involve investing across different geographical regions and industries. Beware of over-diversifying, however, as this can dilute your returns and increase fund costs.
5. Consider opting for a life-cycle fund
Achieving optimal asset allocation can be tricky – even for the most experienced investors. If you’d rather leave the hard work to someone else, you may want to consider investing in a life-cycle fund (more on this above).
A life-cycle fund (otherwise known as a target-date fund) is a type of mutual fund that invests in a diverse mix of assets across various asset classes. It automatically adopts a more conservative approach as you get closer to retirement or your target date. While life-cycle funds have many advantages, they don’t consider your individual risk tolerance or reflect changes in your personal circumstances.
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Cash assets like savings accounts are an important part of any portfolio as they can help to offset the risk associated with other asset classes like equities. If you’re looking for a risk-free way to maximise your cash growth, fixed rate savings accounts may be a good choice.
Not only do they offer competitive interest rates, but they also provide a guaranteed return on your investment for the duration of the term. Plus, all of the fixed rate bonds you’ll find in the Raisin UK marketplace are protected under the Financial Services Compensation Scheme (FSCS) or its European equivalent for added peace of mind.
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