Portfolio asset allocation: what is it and how does it work?

As an investor, you should aim to grow your money with a broad range of assets and asset classes rather than over-specialising.

This enables you to manage risk more effectively while taking advantage of higher-growth assets.

You can also balance out different assets against one another in the hope that when one is falling, another is rising.

This spreading of investments is called asset allocation.

Designing and managing your asset allocation is an ongoing task in itself, so you should make sure you grasp how it works before building your portfolio.

How you proceed will then depend on your own goals and risk appetite.

Read on for an introduction to how asset allocation can work for you.

What is asset allocation?

Asset allocation is how investors decide to distribute their investments across various asset classes such as stocks, bonds, and cash equivalents.

The goal is to find the right mix of risk versus reward for each investor based on their financial objectives, attitude towards risk, and intended investment time period.

Where things can get tricky, however, is in actually making those decisions.

How do you decide which eggs to put in which baskets to ensure that your portfolio is a good fit for your needs?

Firstly, you need to ensure that your portfolio reflects your own risk tolerance as accurately as possible.

Secondly, it should be built around your chosen timescale – for instance, are you investing for 10, 15, 20 or 30 years in the future? Alternatively, are you investing for income?

Thirdly, your portfolio must be sufficiently liquid for your needs, i.e. can you access enough of the money for when you may need it?

Fourthly, how aggressively do you want to pursue growth? Many other factors could influence your portfolio selections – e.g. you may prefer ethical investments, want to protect yourself against economic crises (e.g. with gold), or there may be particular industries or companies that interest you.

The above factors will influence your choice of assets and how much of your portfolio each one occupies.

The last big thing to consider is the balance between the assets.

Some assets have performances that correlate with one another, have an inverse correlation (one rises when the other falls), or have no correlation at all (so they move entirely independently of each other).

A good portfolio will have a balance of all of these types, so for example, the impact of a stock market crash can be absorbed by other assets that aren’t linked to equities.

As you can imagine, there are infinite possible combinations of assets you could arrange in one portfolio.

Exploring your options to find one that suits you can be an exciting challenge.

What are the different asset classes?

Before we start to talk about allocating assets in a portfolio, it’s worth recapping what the different types of assets are.

Here are the major categories:

• Cash: Quite simply, this is money held in a savings account. It may be instant access, delayed access or fixed term, but it doesn’t depend on other assets for its growth, although it can be impacted by interest rates and inflation.
• Property: This can either be physical property (e.g. buy-to-let flats or houses) or shares in a property portfolio or property company. Sources of growth include both property price increases and rental income. Property assets are among the least liquid, i.e. it can be hard to cash in your investment.
• Bonds: Also called fixed-interest securities, these are loans that you make to companies and governments in return for fixed interest after a set amount of time. Risk can vary, but they are generally much less volatile than stocks and shares.
• Equities: These are stocks and shares in companies traded on the stock market. These are among the most volatile assets – i.e. they can gain or lose a lot of value very quickly. This makes them risky but also a strong source of potential growth.
• Commodities: A commodity may be anything from grain and other foodstuffs to things like oil and precious metals such as gold. Commodity prices tend to move independently from the stock exchange, so can provide a good balance (or ‘hedge’) against it.
• Peer-to-peer loans: Peer-to-peer (P2P) lending is similar to bonds in that you are lending your money to businesses and individuals at a rate of interest. However, it’s generally riskier than bonds, since the chance of defaulting is higher.
• Alternative investments: Anything that doesn’t fall neatly under one of the other categories – art and fine wines are examples of alternative investments.

Why is asset allocation important?

Asset allocation is the maxim ‘Don’t put all your eggs in one basket’ as applied to investing.

Spreading your investments around helps to reduce and manage your risk.

However, there’s a bit more to asset allocation than that.

Picking the right assortments of assets can enable you to target the growth you need within the timescale you desire.

In other words, it’s not just a defensive strategy but also an active way to pursue returns.

Sports fans might like the analogy of putting together a football team.

Attacking players would be more volatile assets such as startup equities, overseas equities and riskier type of bonds; in the midfield might be equities of established corporations, perhaps with P2P loans and corporate bonds; while in defence would be government bonds and some cash (which can be seen as the goalie, the last line of defence).

No-onNo ones a team from just strikers or defenders – as any good manager knows, it is all about the blend and the formation.

Rebalancing your portfolio

One crucial thing to remember is that your asset allocation will not stay the same, even if you leave your portfolio alone.

Over time, your risk appetite and your portfolio may grow apart, sometimes because your circumstances have changed but also because of how your investments have performed.

For example, say you have a portfolio that is 70% bonds and 30% shares.

If the shares increase in value, then after a few years, the value of your portfolio may be only 60% bonds and 40% shares.

But this means that more of your money is now in higher-risk assets.

If your risk appetite hasn’t changed, then the wise thing to do is move some of the shares into bonds to achieve a 70:30 balance again.

But what if your shares have done badly so that your portfolio’s net worth is now 80:20 bonds-to-shares?

Counter-intuitively, you might now be advised to move more of your money into shares (even though your shares have lost money) in order to regain that 70:30 split.

And what if your risk appetite has changed?

If you have inherited money and now have more of a safety cushion, you might now be able to take more risk – and so perhaps aim for 60:40 bonds to shares.

Conversely, suppose you are starting a family and are less able to risk large sums of money - you might then be inclined to take a step back and go 80:20 (all these figures are for illustrative purposes only).

What are the different asset allocation strategies?

You will have your own priorities for investing, and these will help to identify and shape your particular strategy.

Here are five asset allocation strategies that have proved popular with experienced investors.

Strategic asset allocation

This is where you base your asset allocation on expected rates of return for each asset class.

With this method, you tend to hold your assets for a long time and rebalance your portfolio at intervals of a few years.

Constant-weighting asset allocation

This is similar to the strategic method, but you rebalance your portfolio much more regularly.

Tactical asset allocation / dynamic asset allocation

Tactical allocation involves taking a more hands-on approach and seizing opportunities in the market as they arise.

It means a near-continual rebalancing of your portfolio, so isn’t one for the casual investor (unless you engage a wealth manager to handle the practical side).

Dynamic allocation is much the same, but even more fast-moving.

Insured asset allocation

As with dynamic asset allocation, this includes actively moving assets to make the most of the market at any one time, but you have a base portfolio value in place to stay on track.

If your portfolio drops below this level, you invest in much lower-risk assets to avoid losing more while you wait for the value to increase.

Integrated asset allocation

This strategy is about balancing your appetite for risk with the aim of growing your wealth.

It may involve elements of all the other four, but ultimately is anchored by your personal financial goals and risk appetite much more than the other strategies are.

How to work out your own asset allocation

Asset allocation can’t entirely protect you from losses or wave a magic want to generate growth, but it is one of the most tried-and-tested ways to construct a portfolio that delivers intended goals.

First of all, though, you need to be clear in your own mind about what your own goals are.

Only then can you start to choose the best mix of assets.

An IFA can help you calculate your risk tolerance and choose the right assets and investment products based on this.