Create and protect wealth, especially during volatile market conditions
Investment asset allocation is a critical component of successful financial planning. It’s diversifying your investments across different asset classes, such as equities, bonds, property, and cash, to minimise risk and maximise potential return. The goal is to create and protect wealth, especially during volatile market conditions.
The dynamic process of asset allocation
Asset allocation is not a static process; it evolves with your changing circumstances, goals, and risk tolerance levels. As you approach retirement, for instance, you might want to adjust your asset allocation towards a more conservative approach, focusing more on income-generating and less risky assets.
It’s important to remember that there’s no one-size-fits-all asset allocation strategy guaranteeing success. The key lies in finding an asset allocation that aligns with your financial goals and sticking with it over the long term.
Future capital or income needs
Your asset allocation should reflect your future capital or income needs, the timescales before those capital sums are required, the income level sought, and your risk tolerance. Investing is all about balancing risk and return.
A thoughtful asset allocation not only spreads risk across different asset classes but can also help maximise returns while potentially reducing the overall portfolio risk. Every investor has a unique attitude towards risk, and their asset allocation should reflect this individuality.
Understanding investment characteristics
Deciding what portion of your portfolio should be invested into each asset class is called ‘asset allocation’. Portfolios can incorporate various assets, each with its own characteristics. For instance, cash is considered safe but offers low returns, bonds provide regular income but are sensitive to interest rate changes, equities offer high potential returns but come with higher risks, and property can provide a steady income and potential capital appreciation but requires a significant upfront investment.
The idea behind allocating your money between different assets is to spread risk through diversification and understand how these characteristics can impact your portfolio performance under varying market conditions.
Looking into the future
Investments can go down and up, depending on your invested assets and market performance. It’s a natural part of investing. Economic, political, and regulatory developments and many other factors can change the potential returns and risks associated with different investments over time. Diversification helps to mitigate this uncertainty by combining a variety of investments.
Moreover, your risk tolerance will likely change over time. Given their longer investment horizon, younger investors may be more willing to withstand market downturns. However, middle-aged investors with responsibilities like a mortgage or family might focus more on protecting against significant losses.
Understanding asset classes
When assembling an investment portfolio, asset allocation is one of the most critical considerations. This involves diversifying your investments across various asset classes to achieve better returns than leaving all of your investment on deposit as cash.
The role of cash
Cash investments often take the form of bank and building society savings accounts or money market funds. These funds invest in short-term bonds and other securities, allowing institutions and larger personal investors to invest cash for the short term.
While money held in the bank is arguably more secure than other asset classes, it’s also likely to provide the poorest return over the long term. However, having some cash allows you to deal with unexpected expenses or income loss without dipping into your core portfolio.
Remember that cash savings accounts are generally not great for long-term investment because the interest is almost always lower than inflation.
Bonds as an asset class
Bonds are IOUs issued by governments or corporations. When you invest in a bond, you’re lending the issuer your money in exchange for regular interest payments (the ‘coupon’) and the promise to return your initial investment at the end of a fixed term.
The riskiness of a bond depends largely on the issuer’s financial strength. High-risk issuers need to offer more attractive coupons to attract investment. Bond prices fluctuate throughout their lifetime due to changes in interest rates, inflation expectations, and the perceived creditworthiness of the issuer.
Investing in equities
Equities, or shares in companies, are considered riskier investments than bonds but can yield superior returns over the long run. Bondholders are prioritised over shareholders when distributing remaining assets if a company encounters financial trouble.
However, equities can potentially have higher long-term returns as share prices rise significantly as a company grows. Returns from equities come from changes in the share price and dividends paid by the company to its investors. Factors influencing share prices include company profits, economic conditions, and investor sentiment.
Property as an investment
Commercial real estate—offices, warehouses, retail units, etc.—is another asset class. Each property is unique; only one fund can own a building or shop. Property values can shift dramatically, illustrating the relative illiquidity of property compared to equities or bonds. Think carefully before securing other debts against your property, your commercial property may be repossessed if you do not keep up repayments on your mortgage.
Rental income is typically the main driver of commercial property returns. Property owners can enhance their assets’ income potential and capital value through refurbishments or improvements. Managed properly, the stable nature of the property’s income return makes it an appealing choice for investors.
Unfortunately, we lack this clairvoyant ability
The concept of viewing the future is an enticing one, especially when it comes to investments. We wouldn’t need to diversify our investments if we had this ability. Instead, we could choose a future date when we want our money returned and then pick the investment that would yield the highest return by that date. This investment could be anything from a company share, a bond, gold or any other type of asset. Unfortunately, we lack this clairvoyant ability.
The strategy of diversification serves as a solution to this uncertainty by integrating a variety of different investments. To optimise the performance potential of such a diversified portfolio, managers continually adjust the composition of assets they maintain in response to current market conditions. These adjustments can occur at several levels, including the overall asset blend, the target markets within each asset class, and the risk profile of underlying funds within those markets.
Generally speaking, a climate of positive or rebounding economic growth coupled with a healthy risk appetite often leads to a higher weighting in equities and a reduced exposure to bonds. Within these asset groups, the manager may transition into more aggressive portfolios when markets are thriving and adopt more conservatively during challenging conditions. Factors like local economic growth, interest rates, and political climate also impact the balance between markets within equities and bonds.
Regarding the underlying portfolios, managers usually take a more defensive stance during periods of low-risk appetite. For instance, equities might favour larger companies operating in sectors less dependent on strong economic growth. On the flip side, when there’s a high-risk appetite, underlying portfolios are likely to increase their exposure to areas of the market that are more sensitive to the economy and to smaller companies.
A well-planned asset allocation strategy can help you safeguard wealth and meet financial goals. Regularly reviewing and adjusting your asset allocation can ensure it remains aligned with your changing needs, goals, and risk tolerance.