Quite often when you’re talking about investing you can come across a phrase that might seem a little jargon-y or confusing. Certificates of deposit. Earnings per share. Market capitalisation. Talk sense, man! Luckily, asset allocation isn’t one of them, as it is exactly what it says it is. Asset allocation is simply how you allocate your assets.
Done! Next blog.
Well, not quite yet. You see, it’s a simple concept but it can have huge ramifications on your investments. You might think of it as diversification, but it’s actually more than that. It isn’t just dividing up your money into different pots. It’s strategically dividing up your money into different investments based on what stage of life you’re at (i.e. are you in your early 20s or nearing retirement?), how much risk you’re willing to take, and whether you have specific goals in mind. Goal only five years away? Maybe you need to be a bit bolder with your asset allocation to make it grow quickly. Thinking about retiring next year and living off the income? You need to make your pot as safe as possible, and fast! In both examples, we’re taking into consideration our risk appetite, our goals, and how long we’re going to invest for – all with the intention of balancing risk and reward.
Strategically dividing up your money
We’re well into our series on investing, so you now have a good understanding of the basic investment concepts – things like Equities, Fixed Interest assets, and Index Funds. In our last post on funds, we talked about what would happen if you put all of your money in Tesco, verses if you’d investing in an Index fund. Essentially, if you’re only invested in Tesco and Tesco tanks, you lose a lot of money. If you’re invested in an Index Fund and Tesco tanks, you’re much more insulated from the downside. Investing in a fund is one way of minimising risk by not putting all of your eggs in one basket. It’s a type of diversification because you don’t just own a share in one company, you own the whole market.
Asset allocation is another way of spreading the risk, but rather than spreading it within one asset class (Equities, in the Tesco example above), we’re spreading the risk across different asset classes. How important is that? Get asset allocation wrong, and it can have a hugely negative impact on your investments. But, get it right and it can maximise the upsides available, mitigate the risk, and actually improve the performance of your investment portfolio as a whole.
An example allocation
Let’s consider the extremes, and then a more likely allocation. Imagine you have £10,000 to invest. You’re looking to grow that money quickly, and you’re willing to take on a lot of risk. If you end up losing it all, no bother. You’d rather go out in a blaze of glory, sipping some kind of cocktail which comes with an umbrella. Well, you’d likely want to invest 100% of your money in equities. Perhaps that will be in equity funds, and potentially you’ll even dive deeper into more uncertain funds where the upsides are huge but so are the downsides! This would mean that 0% of your money would be in bonds, and 0% of your money is held in cash or an equivalent.
If that asset allocation sounds pretty scary, then good. Because it is. That said, there are bound to be people out there willing to take that risk, and for whom that allocation would be right.
At the other end of the scale, you’ve got the person who keeps all of their money in cash under the mattress. Each year their money loses value (due to inflation) because none of it is working for them. Also bad. They aren’t diversified across investment types, nor within those investment classes.
So, what we’re after is some kind of balance. A mix of equities, so that you can benefit from growth in the stock market, fixed interest assets (such as bonds), so you are offered some protection when the stock market falls (traditionally, bond values tend to rise when the stock market falls), and cash that is readily available or in a simple easy-access savings account, and secure.
Just how important is it?
David Swensen is probably a name you haven’t heard before. Swensen is the Chief Investment Officer at Yale University in the US, and author of Unconventional Success: A Fundamental Approach to Personal Investment. Already, he sounds like a guy you should listen to. But then, you find out that after joining Yale in 1987, his approach produced a 20-year unbroken record of positive returns, resulting in a growth of the Yale endowment fund from $1bn to $17bn. Okay, we’re definitely listening now.
Swensen’s portfolio, which has been largely documented, is spread across a whole host of asset classes. One of the most important lessons from it is that his portfolio doesn’t have one major player – the money, and therefore the risk, is spread. How important does Swensen think asset allocation is? In an interview with Tony Robins, he said that there are only three tools for reducing your risk and increasing your potential for financial success: 1, security selection. 2, market timing. And 3, asset allocation. “Overwhelmingly, the most important of the three is asset allocation. It actually explains more than 100% of returns in investing.”
So now you know understand what asset allocation is and why it’s so important. This is just an introduction, of course, as the theories, mathematics and opinion on successful asset allocation would turn this blog into a Game of Thrones length series of books.
If you’re looking to take some action, a good next step would be to work out your longer term goals for investing, and then consider your risk appetite. Then, it’s time to do some extra reading on asset allocation, or to give us a call.
This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.
The value of investments can fall as well as rise. You may not get back what you invest.
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