Things to know about asset allocation
25 March 2013 10:32 am
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With literally hundreds of stocks, bonds and unit trusts to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with stock picking might be the wrong approach. Instead, you should start by deciding what mix of stocks, bonds and cash you want to hold - this is referred to as your asset allocation.
What is asset allocation?
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks and real estate, etc. Each asset class has different levels of return and risk, so each will behave differently over time.
For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a settlement for mediocrity, but for most investors it’s the best protection against a major loss, should things ever go amiss in one investment class or sub-class.
The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds and to cash on the sidelines.
We must emphasize that there is no simple formula that can find the right asset allocation for every individual - if there were, we certainly wouldn’t be able to explain it in one article. We can, however, outline five points that we feel are important when thinking about asset allocation:
1. Risk vs. return
The risk-return tradeoff is at the core of what asset allocation is all about. It’s easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest ‘potential’ (stocks, bonds and units) isn’t the answer. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return.
Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you can’t keep invested through the short-term fluctuations of a bear market, you should cut your exposure to equities.
The main goal of allocating your assets among various asset classes is to maximize return for your chosen level of risk, or stated another way, to minimize risk, given a certain expected level of return.
Of course, to maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes. Figure 1 compares the risk and potential return of some of the more popular ones:
Equities have the highest potential return, but also the highest risk. On the other hand, Treasury bills have the lowest risk since they are backed by the government, but they also provide the lowest potential return.
Figure 1 also demonstrates that when you choose investments with higher risk, your expected returns also increase proportionately. But this is simply the result of the risk-return tradeoff. They will often have high volatility and are therefore, suited for investors who have a high risk tolerance (can stomach wide fluctuations in value) and who have a longer time horizon.
It’s because of the risk-return tradeoff - which says you can seek high returns only if you are willing to take losses - that diversification through asset allocation is important. Since different assets have varying risks and experience different market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities.
So, while part of your portfolio may contain more volatile securities - which you’ve chosen for their potential of higher returns - the other part of your portfolio devoted to other assets remains stable. Because of the protection it offers, asset allocation is the key to maximizing returns while minimizing risk.
2. Don’t rely solely on financial software or planner sheets
Financial planning software and survey sheets designed by financial advisors or investment firms can be beneficial, but never rely solely on software or some predetermined plan.
But standard worksheets sometimes don’t take into account other important information such as whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on a set of simple questions that don’t capture your financial goals.
Remember, financial institutions love to peg you into a standard plan not because it’s best for you, but because it’s easy for them. Rules of thumb and planner sheets can give people a rough guideline, but don’t get boxed into what they tell you.
3. Determine your long- and short-term goals
We all have our goals. Whether you aspire to own a vacation home, to pay for your child’s education or to simply save up for a new car, you should consider it in your asset allocation plan. All of these goals need to be considered when determining the right mix.
For example, if you’re planning to own a retirement luxury apartment on the beach in 20 years, you need not worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments.
4. Time is your best friend
Some experts have said that for every 10 years you delay saving for retirement (or some other long-term goal), you will have to save three times as much each month to catch up. Having time not only allows you to take advantage of compounding and the time value of money, it also means you can put more of your portfolio into higher risk/return investments, namely stocks.
5. Just do it!
Once you’ve determined the right mix of stocks, bonds and other investments, it’s time to implement it. The first step is to find out how your current portfolio breaks down. It’s fairly straightforward to see the percentage of assets in stocks versus bonds, but don’t forget to categorize what type of stocks you own (small, mid or large cap).
You should also categorize your bonds according to their maturity (short, mid or long term). If you choose to invest in unit trusts, you have to dig deeper and figure out where fund assets are invested.
Bottom line
There is no one standardized solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you don’t have, don’t worry. It’s never too late to get started.
It’s also never too late to give your existing portfolio a facelift. Asset allocation is not a one-time event; it’s a life-long process of progression and fine-tuning.
(Source: Investopedia)