Asset allocation is the practice of balancing risk versus reward, an investment strategy to widen or spread one’s portfolio (range of investment products) across a wide range of different asset classes and geographical regions in order to minimize the risk of all the investments falling simultaneously.
The aim is also to get the best possible compound returns on the investments.
By spreading one’s investments across commodities, property, bonds, stocks, private equity and cash, the impact of price volatility on any one of the asset classes on the overall value of the portfolio is reduced.
The Financial Times Lexicon says that asset allocation is:
“The process of spreading, or ‘diversifying’, your investments across a range of different asset classes and geographical regions – to minimize the risk of all your investments falling in value at the same time, and to maximize the potential for smoother, and therefore higher, compound returns.”
Asset allocation means eggs in different baskets
Put simply, asset allocation is the investor’s equivalent of not placing all his/her eggs in one basket.
Most successful investors claim that asset allocation is a crucial factor in determining returns on an investment portfolio. It is based on the principle that different asset classes perform differently in a range of economic and market conditions, i.e. they do not all fluctuate in tandem.
The three principle asset classes – fixed-income, cash & equivalents, and equities – have varying levels of risk and return, so each one over time will behave differently.
It is also extremely important to make the right choice of asset classes to include in your portfolio.
There is no magic formula for the right asset allocation. What mix of investment classes an individual might choose depends on his or her risk tolerance, goals and investment horizon (how long you plan to invest before obtaining your goal).
A simple portfolio may, for example, include just three investment classes, with a percentage of all funds divided among stocks, bonds and cash alternatives.
A more complex strategy may include many more asset classes and sub-classes, e.g. stocks may be broken down into subcategories such as small cap stocks, large cap stocks, high-tech stocks, etc.
“Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”
If your asset allocation is done successfully, investments in one asset class may be performing poorly, while those in another category will be doing well. The gains in the later will make up for the losses in the former, thus minimizing the overall effect on your investment portfolio.
It is important to remember, however, that all investing involves risk. There are no guarantees.
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