Over the past few weeks we have talked about asset classes, which are the different types of things you can invest in. Today we are going to discuss the importance of allocating your money into the right mix of asset classes in a process called Asset Allocation.
There have been countless studies which show that asset allocation is a major determinant in the outcome of any investment portfolio.
What is asset allocation?
Asset allocation is the process of deciding how much of your money should go into each asset class and geographical region. Here’s a simplistic example:
Cash: 2%
Equities: 50%
Bonds: 40%
Other/sexy stuff: 8%
This is of course just a very high-level example, but it’s a starting point for our discussion.
Each of these asset classes (except the cash element) can be further broken down. So, for example, the equity portion of the above portfolio might be broken down into:
UK equities: 15%
US equities: 12%
European equities: 10%
Far East equities: 8%
Emerging Market equities: 5%
You can drill down even further as each element will carousel down to its most basic component. UK equities for example could be broken down into large/small companies or finance/technology sectors.
Which asset allocation is right for me?
This will depend largely on the 3 things that we discussed in my post from a few weeks ago, namely:
- Your time horizon
- Your attitude to risk
- Your capacity for loss
It also depends on what your investment goal is.
Strategic and Tactical Allocations
One final point here is to understand the basic concept of, and differences between strategic and tactical asset allocations.
A strategic asset allocation is a long-term plan which you stick to through thick and thin. It is sometimes known as ‘buy and hold’. You determine how much of your money should be invested in each asset class (such as shares or bonds), and once you have decided, you stick with that allocation no matter what happens, rebalancing periodically to keep your allocation as intended at outset.
The basis of strategic asset allocation lies in something called Modern Portfolio Theory, which suggests that markets are efficient at all times so there is no point in trying to ‘beat’ them, and rather than trying to “bet” on the direction things will go, you should follow a static allocation to take advantage of the efficiency of markets over time. Buy + Hold = profit over time!
By using a disciplined strategic approach, you can avoid making emotional short-term decisions based on current market or geo-political events.
A tactical asset allocation on the other hand, represents your current view on the world and so may change as time goes by. If you generally think that holding UK shares is a good idea, but right now, you’re a bit worried about them, you may hold less right now than you would normally. This temporary shifting of the portfolio is known as being a ‘tactical’ investor.
Generally speaking, employing a strategic asset allocation and then rebalancing your money back to that original allocation once a year will do the trick for most people.
What do you think? Do you agree? Or maybe you have some opposing views? If so, that’s fine, let me know…
If you are up for it, let’s do this again – same time next week?
In the meantime, remember you can always email me at planning@claritylfp.co.uk if you have any questions about investing or any other financial matter, or if there is anything you would like me to cover in a future blog.
(The value of investments and the income they produce can fall as well as rise, you may get back less than you invested).
Until next time…
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