I'm relatively new to investing, can you please explain what asset allocation is?
Holly Warburton, from our discretionary investment management team, answers this month’s question.
In this series of articles, we hope to break down some of the myths surrounding investing and make sense of the most common expressions used.
This month, we thought we would tackle asset allocation. In a nutshell, this simply refers to how a portfolio is divided up across different investments or asset types such as cash, equities or bonds.
The investment decision regarding what asset allocation or strategy may be suitable for your needs is a personal one. As a starting point, deciding on the most appropriate approach depends on how long you have to invest (your investment time horizon) and your ability or want to tolerate risk (your risk appetite).
Your chosen asset allocation won’t necessarily remain the same, it may change due to the market environment or at different times in your life as your circumstances change.
Asset allocation is based on the idea that individual assets within overarching groups (i.e. equities) have similar characteristics in terms of risk profile and returns but different asset groups (i.e. equities compared to bonds) have different attributes. Furthermore, depending on what is going on in the world different asset groups typically (but not always) move in different directions. Because of this, diversifying across multiple asset groups tends to bring down the overall risk profile of a portfolio by “not having all of your eggs in one basket”.
Some of the main asset classes that could form part of an investment portfolio are:
At first glance, it might appear strange to include cash in an investment portfolio, but cash serves several important roles. It could be used to ensure liquidity to match future liabilities such as retirement or an upcoming payment, as a hedge against adverse market events or as “dry powder” at a time when other assets look expensive.
Equities (shares in companies)
An equity investment represents ownership of a company. In order to raise capital, companies may issue shares to investors. When buying a share, the investor has part ownership of that company. The value of a share is reflected in its daily price which moves according to the supply and demand for that share in the market. Over the long term, this asset class typically provides a higher return but exhibits higher volatility levels (moves around in value) over shorter periods of time. Investors risk bearing losses if the company performs poorly and the value of the shares fall. If a company goes out of business, investors can lose all of the money they had invested in it.
Fixed Interest (Bonds)
A fixed-interest investment is one that pays interest at a fixed rate throughout the term of the investment. This may be a loan by you to a government, company or overseas country. On the whole, bonds are generally deemed less risky than equities as you rank higher in the capital structure, and you are also paid a fixed return. They also tend to trade in opposite directions to equities, that is to say they are negatively correlated. Investors can hold bonds to help increase the diversification benefits of their portfolio, in addition to achieving a higher level of income. If equities fall, bonds tend to increase in value and vice-versa. However, this is not something which always happens.
Alternatives are other types of investments that have different characteristics to shares and bonds. This asset class has expanded considerably over the last couple of decades and the main examples include commodities, commercial property, infrastructure, private equity and hedge funds. The risk/reward profile of these different assets can vary considerably and some of them can be highly illiquid, such as private equity.
Part of an investment manager’s role is to establish, using the above assets, an appropriate asset split or allocation in order to meet the investment objectives of the client and manage the volatility level as well – essentially balancing the risk versus reward.
As always, it is important to speak to an investment manager to ensure the asset allocation is right for you based on your objectives and risk tolerance.
For more information on this subject, listen to our podcast “The importance of portfolio diversification”.
If you’d like to find out more about investing with Ravenscroft, or if you have any questions you’d like us to answer, please contact us.