Asset allocation

Asset allocation is a technique that aims to balance risk and create diversification in a portfolio by investing across asset classes. The three main asset classes are equities, bonds and cash. I shall also add property and commodities.

Each asset class is expected to reflect different risk and return characteristics, and will perform differently in any given market environment. For example, while one asset class increases in value, another may not increase as much or may even decrease. While the prospect of having one portion of a portfolio decreasing in value while another portion is increasing may seem a little self-defeating, for most investors it’s the best protection against the major loss that would result from being fully exposed to a “crash” in a single asset class or subclass.

The importance of Asset allocation

Numerous academic studies have illustrated the importance of asset allocation – more than 90 per cent of returns over the long run come from what mix of different assets you hold. By contrast, the things that most investors concentrate on, such as stock-picking, are virtually irrelevant.

Risk Hierarchy of Asset Classes

It is generally accepted that the order of the asset classes in terms of risk is as illustrated below, with cash having the least risk and commodities the most:

Commodities

Equities

Property

Bonds

Cash

Investors who can afford to tie-up their cash for longer are likely to seek a greater exposure to more “risky” assets such as equities and commodities in the pursuit of higher returns. Conversely, investors with a shorter investment time horizon should have a greater proportion of their portfolio invested in safer cash and bonds.

A “rule of thumb” which some may find useful suggests that the equity-element of an individual’s portfolio should be approximately equal to (100 – person’s age) eg a 40 year-old should have about 60% of his or her portfolio invested in equities, with 40% in cash and bonds. Adopting this approach will mean that by the age of 70, the ratio of equities to cash and bonds should be around 30:70.

Risk Hierarchy within Asset Classes

It is also worth noting that there are different levels of risk within each asset class. Factors such as political stability and the extent to which an economy is developed will influence the level of risk of investments within the equity and bond asset classes. So, for example, equities and bonds relating to the developed economies of the West will be less risky than those of emerging economies such as Brazil, Russia, India and China (the so-called ‘BRIC’ countries).

Within the equity asset class, risk will also depend on the size of the underlying companies (measured by market capitalisation) – larger companies will be less risky than smaller companies.

Within the bond asset class, government bonds (or gilts) are less risky than corporate bonds.

It is worth noting that the risk hierarchies above assume that all other factors that influence risk are equal. For example, when considering bonds, it is assumed that both relate to the same “market” in broad terms eg we are comparing US corporate bonds with US government bonds. Without this qualification, the relative risk is not so clear eg Greek government bonds might be considered more risky than the corporate bonds of large US companies.

There is no ‘magic formula’ for assessing the optimal asset allocation for every individual. However, I hope that the above discussion has illustrated the importance of regularly reviewing one’s portfolio to ensure that it remains balanced and consistent with the individual’s investment priorities and views.

If you’re not sure what sort of asset allocation is appropriate for you, complete the questionnaire on the Vanguard website. Visit https://personal.vanguard.com/us/FundsInvQuestionnaire

The importance of diversification

Diversification within each asset class is just as important as diversifying across asset classes. Ensure that your holdings within a particular asset class are spread across a range of subclasses and industry sectors. This is most easily achieved by investing in ‘pooled’ or ‘collective’ investment funds such as unit trusts or investment trusts. We’ll consider these in more detail in the next section.

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