What is Asset Allocation, and How Does it Work?

Asset allocation defines how capital should be spread across different asset classes based on investor time horizon and risk tolerance.

by | Last updated 18 Dec, 2022 | Diversification, Investing Basics

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Asset allocation is one of the most important parts of an investment strategy. It defines how much of an investor’s portfolio should be invested across different asset classes to achieve their investment objectives. When used correctly, it can help maximise returns while keeping risk in check, similar to diversification.

How does this work? Just like every business, every asset class has different characteristics. For example, stocks are typically more volatile but offer greater growth potential. Meanwhile, high-grade bonds don’t tend to deliver much in terms of price appreciation, but interest coupon payments provide a reliable stream of fixed income.

Each asset class is suitable under different investor circumstances and objectives. And deciding on the right blend is ultimately a personal decision. However, a common starting template for an average middle-aged investor in 2022 is usually 10% cash, 60% stocks, and 30% bonds.

By spreading an investment portfolio across multiple types, the impact of one asset class suddenly dropping can be mitigated by the stability of the others. In other words, it helps investors to avoid putting all their eggs in one basket. That’s why asset allocation is so important on an investing journey.

The two primary factors that investment advisers use to develop an asset allocation strategy are:

  • Time Horizon – How long until an investor intends to withdraw their capital?
  • Risk Tolerance – How much risk is the investor willing to take to achieve their investment objective?

4 instruments used for asset allocation

There is a plethora of asset classes that investors can diversify across. And depending on the complexity of an individual’s financial position, asset allocation strategies can get pretty complicated.

However, for basic strategies, blending across cash & equivalents, stocks, bonds, and real estate is the traditional approach still used today by professional money managers.

1. Cash & Equivalents

While it’s not often considered an investment, depositing cash in a bank account generates a small return in the form of interest. With substantial consumer protections implemented over the decades, placing money in a bank account is arguably one of the safest investments an individual investor can make. Even if the bank were to go bankrupt, deposits up to £85,000 are insured by the Financial Services Compensation Scheme (FSCS).

Cash is a highly liquid asset and can typically be accessed instantly. But consequently, savings accounts don’t provide much in terms of wealth generation. In fact, the average interest rate on British savings accounts in December 2022 is only 0.19%.

Other investment vehicles, such as money market funds and certificates of deposits, provide slightly higher returns than a regular savings account and retain high levels of liquidity. However, they still fail to deliver meaningful growth, let alone stay ahead of inflation.

Generally speaking, the cash allocation within a portfolio is kept proportionately low. That way, money is at hand to capitalise on investment opportunities, but the majority is invested in wealth-building asset classes.

2. Stocks

Out of all the major asset classes, stocks have delivered the greatest investment return over long time periods. Depending on which stock market index is used as a benchmark, this asset class typically generates between 8% to 10% annually.

However, this doesn’t come without risk. Stocks can be notoriously volatile, especially during economic turmoil, which can quickly destroy wealth rather than create it.

Sucessfully investing in stocks requires detailed stock picking knowledge or the ability to identify talented mutual fund managers. But most of all, it requires patience and emotional discipline – something many investors lack. And it’s one of the main reasons why index funds are gaining such popularity.

3. Bonds

Bonds typically provide some shelter against volatility. Historically their returns have significantly lagged behind stocks. However, providing an investor isn’t dabbling in junk bonds, there’s a considerably lower chance of destroying wealth as this asset class carries low levels of risk.

Their low-risk profile makes bonds a popular defensive investment that provides a balance against more volatile asset classes like stocks. However, with interest rates being kept near zero per cent since the 2008 financial crisis, high-grade bonds have struggled to deliver meaningful returns creating opportunity costs for investors.

4. Other

Beyond cash, stocks, and bonds, plenty of alternative asset classes can contribute to a portfolio. Real estate is arguably one of the most popular, with families owning their own homes through a mortgage.

However, some more obscure examples include:

  • Commodities
  • Currencies
  • Cryptocurrencies
  • Collectables
  • Hedge Funds
  • Venture Capital
  • Private Equity
  • Financial Derivatives

Many alternative investments provide attractive potential returns. But they can vary significantly in terms of risk. And for some, they can be difficult to sell.

What’s the difference between asset allocation and diversification?

Asset allocation and diversification seem similar, considering both are all about spreading investment risk. However, some stark differences separate the two.

Diversification defines the distribution of investments within a single asset class. For example, how many large-cap stocks should an individual investor own versus small-cap stocks? Or which industries, such as technology, pharmaceuticals, and utilities, should be in a portfolio and with what weighting.

Asset allocation defines the distribution of capital across multiple asset classes. For example, how much money should be invested in stocks versus bonds or real estate?

How do asset allocation strategies change with age?

As investors get older, retirement inches closer, causing time horizons to shift. Eventually, investment objectives change from building wealth to protecting it. And as such, asset allocation strategies need to be updated to reflect this.

Generally speaking, younger investors are often capable of taking on higher levels of risk due to their longer time horizons. That makes stocks a far more interesting asset class and subsequently could become a more dominant portion of their asset allocation strategy.

On the other hand, investors aged 50 and above are likely getting closer to retirement, making them less able to take more significant risks. As such, bonds and cash equivalents may be more suitable, receiving a higher weight than stocks.

What is portfolio rebalancing?

Because the price of investments is constantly changing, the balance between asset classes can shift over time.

For example, suppose an investor has 60% of their portfolio in stocks. But after a recent stock market rally, that proportion has grown considerably, and stocks now represent 80% of the investor’s portfolio.

In this scenario, the portfolio has fallen out of balance as defined by the asset allocation strategy. And therefore, to prevent excessive risk, the portfolio needs to be rebalanced either by selling some shares or by investing additional capital into bonds.

Portfolio rebalancing can be a tricky process. And many investors turn to an investment adviser to provide guidance. However, this can be prohibitively expensive for lower net-worth individuals. Fortunately, there is a more cost-effective alternative called automatic rebalancing, whereby a trading algorithm makes the necessary decisions on behalf of an investor.

The bottom line

Many professionals view asset allocation as one of the most important factors in an investment strategy – even more so than picking individual instruments like stocks.

It’s important to remember there isn’t a one-size fits all allocation strategy. The process is highly dependent on individual circumstances. And investors need to consider their risk tolerance and time horizon when deciding what blend will work best for them.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Saima Naveed does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.

Written By

Saima Naveed

Saima spent the early days of her career advancing the finance office of a prominent manufacturing business. After taking a sabbatical, she decided to use her expert knowledge and apply it to the stock market. Now, 10 years later, she manages a substantial portfolio built using detailed and thorough analysis.

Outside The Money Cog, Saima is an avid supporter of empowering women in the workplace. She is currently working very closely with Women of Wonders Pakistan to help other women achieve their career goals.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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