How Asset Allocation Works


asset allocationWith so much financial news changing all the time and a huge choice of where to invest, how do you decide the division of your investments? Here is how asset allocation works.

Asset allocation

Asset allocation is the process an investor uses when deciding how to divide up investments between asset types. You don’t want to put all your eggs in one basket.

Here’s a simple example. A portfolio of 75% bonds and 25% shares should be less volatile than if the split was the other way around. It would probably show less growth, but should generate a steadier income over time.

You can never guarantee against investment losses, but diversified portfolios can provide less volatility over the longer run.

Risk tolerance

A defensive approach to your asset allocation is for a low tolerance to risk. Your risk tolerance, or attitude to risk is determined by your ability to absorb losses. To take pensions as an example, you can afford to have some losses when you’re saving for your pension in your twenties. You have plenty of time to recover and continue saving for your retirement. That means your risk tolerance can be higher.

You’ll have less opportunity to recover from losses as you get closer to retirement, so you’ll have a lower tolerance for risk. As you get closer to leaving work, if the returns are there, you’ll move your investments from shares into bonds.

You can reduce your risk without reducing your returns too much, by spreading your money across assets that perform differently according to the economic environment.

Investing for growth

Asset allocation can be more elaborate. As mentioned, assets perform differently according to the economic environment; a portfolio can match the economic situation.

For example, when the US economy performs well and interest rates increase, just like now, the dollar becomes stronger. Because emerging economies tend to trade in dollars and their debt to foreign investors is in their local currency, their shares tend to underperform. That’s because they are paying more for their debt. The cost of the goods they sell to developed markets like the EU increase, so they become less competitive too. In this situation, you might invest in emerging market bonds for greater returns and move out of their shares as dividends are likely to reduce.

Asset classes

There are more asset classes than just bonds and shares, although these are the main two used by retail investors. Other assets can include property, commodities and other forms of debt, like peer to peer lending.

If the whole decision making process becomes too complicated, then you may choose to leave it to an active fund manager. Multi-asset funds invest across a range of assets to give a mix of equities, bonds, property and currencies in a single portfolio.

The fund manager adapts the asset allocation in response to changing market conditions and events and to act on opportunities. You can choose a fund according to your expected returns or risk tolerance and hold it in your stocks and shares ISA.

Even if you don’t need to change your investments immediately, contact us today for an initial consultation on how your asset allocation can be improved.

If you’re new to investing and would like to know how to approach it, you can read more by clicking here.

 

Past performance is not a guide to future performance. The value of investments will fluctuate, which will cause asset prices to fall as well as rise and you may not get back the original amount you invested

The Financial Conduct Authority does not regulate tax and trusts.

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