It is widely acknowledged that asset allocation is one of the most, if not the most, important decisions when investing. The selection of individuals stocks or asset classes is secondary to the proportion of those asset classes within the portfolio. It is the asset allocation which is the main driver of results.
Asset allocation defined
Asset allocation is a way to implement an investment strategy. Asset allocation implies an investment strategy that attempts to balance risk and reward by adjusting the proportion of each asset in an investment portfolio. The proportion of each asset class will be defined based on investment goals, risk tolerance and the time you plan to invest for.
Someone who needs their savings in the next year or two might choose to have a conservative asset allocation made up of things like cash and short-term bonds. Whilst somebody saving for a retirement that is decades away is more likely to have a high equity allocation. Risk tolerance should also be considered when deciding on asset allocation, investors need to feel comfortable with the movements they see in their portfolio performance.
What are assets?
Anything you hold as an investment is known as an asset. This could range from a property holding, stocks in an oil company, or even Chinese currency. The three main asset classes are equities, fixed-income, and cash or equivalents. Each of these have different levels of risk and return, and so, will behave differently over time.
At Moneyfarm we use exchange-traded funds (ETFs) to build up our asset allocation; these are a passive tracking instruments. ETFs track a market, such as the FTSE 100, and will be made up of all the shares in that market. You buy into that ETF and your performance will track the performance of that market. We use ETFs across a range of markets to give you a diversified portfolio.
The benefit of asset allocation
Asset allocation enables you to manage the risk in your portfolio. Asset classes rarely go up and down in sync with one another; therefore, having exposure to a range of asset classes limits the risk impact of any one asset class.