This key phrase is vital to successful long-term investing. Here I introduce it and explain why.
What is Asset Allocation?
The short answer is “one of investing’s most important concepts”. In a nutshell, asset allocation is a process that spreads your money across different types of asset in a way that takes account of your;
· Age and time horizon
· Tolerance for risk
· Personal milestones
Here we’ll look at the bare bones of this vital component of any successful long-term investment strategy.
A key distinction
Perhaps the best place to start is with what asset allocation is not. This may be summarised as follows;
Asset allocation is not about picking individual securities such as shares – it is much broader than that and involves making decisions about what proportion of your wealth will be invested in asset classes such as stocks, bonds, cash and property. A fuller breakdown of these is given here;
The key to understanding asset allocation is realising that over the long-term these asset classes perform differently and also have different characteristics. For example, history shows that bonds and stocks tend to perform well in different circumstances, so by holding both you maximise your chances of making positive returns in most situations. Equally, if you need cash at a specific point in the future you don’t want to be liquidating long-term holdings of shares during a downturn or trying to quickly sell a property in a slow market.
Types of asset allocation
Clearly the proportion of your capital committed to, say, bonds as opposed to stocks can vary. This decision will, in turn, affect your expected level of overall return. As a rule of thumb, the greater your allocation to shares, the more volatile your portfolio will be but you will also probably earn higher long-term returns than would be possible from a more conservative approach. So where to start? Enter the concept of strategic asset allocation, which spreads your money across different asset classes according to your risk tolerance.
That said, asset allocation is not to be seen as static and rigid. Tactical asset allocation recognises that there are periods that favour certain assets over others. A tactical investor may reallocate, or at least reweight, their exposure to take advantage of this;
The tweaks to a portfolio may not be very large in practice but they do seek to take advantage of shorter-term market conditions and allow the investor, or Investment Manager, some flexibility to do so.
However, regardless of the extent to which tactical allocations take place, all long-term wealth management must be dynamic. For example, the asset allocation of someone who is 25 and starting a family may change quite dramatically once they approach retirement.
Staying on track
Clearly, having decided on an initial asset allocation, market conditions may alter it. For example, if share prices rise strongly, an investor may find themselves overweight shares relative to say bonds. Rebalancing is the name given to the process of making the necessary adjustments to a portfolio to bring it back into line.
The frequency with which this is done requires a bit of judgement to ensure it is done often enough to maintain a target allocation but not so often that it ends up costing too much in terms of charges.
A broad investing framework
One way to start what can seem to a novice like a fairly daunting process is to adopt a three-pronged approach to your saving and investing strategy as follows;
The hard part may appear to be identifying milestone-based commitments in terms of both the amount and timing. However, most of these can, in fact, be predicted. Take school fees – you can predict exactly when you will be committed to pay them once you have children and estimating the amount is also possible, making a few assumptions along the way. This sort of exercise will then naturally reveal where and how your funds should be allocated to achieve the best risk/return trade-off.
To find out more about this, please get in touch with our Wealth Planning Team via an Investment Manager.