What is asset allocation?
Asset allocation is the process of deciding how to divide investment money across different asset categories. The aim of asset allocation is to reduce your risk whilst maximising the return on your investment.
In broad terms, there are four main types of asset categories: cash, shares (also called equities), property and bonds (also called fixed-interest securities/stocks). Each asset category, or class, has a different level of return and risk.
There’s no such thing as ‘good’ or ‘bad’ allocations. You just need to find the mix that’s right for you. That will depend on a number of factors such as your appetite for risk, how long you’re investing for, your life stage and what you want to achieve from your investment.
Deciding how to allocate your assets is a really important decision. It can have a massive impact on the success of your investment over the long term.
Why is asset allocation important?
You’ve heard the saying “don’t put all your eggs in one basket”. Well, the basic theory of asset allocation is that you can make your money ‘safer’ by splitting it across asset classes (putting it in different baskets, if you like).
Different asset classes respond to market forces in different ways. So when one asset class goes down, another goes up. That means any losses you might suffer are, at least in part, offset by wins in other areas.
As an investor, getting your asset allocation right is the best protection you can have against major losses should anything go awry with one asset class.
How do we allocate assets?
Allocating assets is about balancing risk. In general, shares are considered most risky, but with most potential for growth in the long term. Cash is generally the least risky, but with less potential for growth.
When we decide how to split your investment across asset classes, we ask lots of questions to help us figure out the right balance for you. We’ll try to find out things like:
- How comfortable are you with risk?
- How much do you have to invest?
- What are your investment goals?
- How long are you investing for?
- How old are you?
There are tools we can use to help us model the right allocation for you based on this information. But, here at Face to Face Finance, we also look at the bigger picture. We take into consideration things like whether you’re a parent or have other dependents and what other financial protection you have in place. We don’t just stick you in a standard plan because it’s easier for us. We want it to work for you.
A quick guide to asset classes
Once we have a good picture of you, your appetite for risk and your investment goals, we can allocate your assets across the most appropriate classes for you. Here’s a very brief summary of the main asset classes to give you a bit of background:
- Bonds or fixed interest: when you buy a bond, you’re essentially lending money to a company or government for interest. Government bonds are generally issued to fund public spending projects, like new schools. A company may issue corporate bonds as a way of financing new business opportunities. The government or company taking out the loan pays a fixed interest rate over a given time period until the loan is repaid. Bonds tend to offer a more predictable income for investors.
- Property: when you invest in commercial property, you’re investing in a physical asset – bricks and mortar. Returns come in the shape of rent and appreciation of building values. You’re not just buying into the structure of the building. You’re also buying an interest in the land that the building sits on. This is a key factor in the long-term value of property.
- Equities or shares: equities are shares of ownership in a company. They are traded on the stock market and the fortunes of the company are reflected in their share price. When you buy equities, you’re effectively becoming a part owner of that business. These tend to be the most volatile asset class in the short term. This class can be broken down further based on location…
- UK equities/shares: the companies are based in the UK
- Developed market equities: the companies are based elsewhere in the world, but in places with developed economies and generally accepted currencies.
- Emerging market equities: the companies are based in countries with relatively underdeveloped economies (generally a more volatile, riskier class but with higher potential returns).
- Cash: cash tends to be held in bank accounts where you can gain interest. Cash funds can also use their market power to get better rates of return than you’d get through a regular bank account. For example, by investing in very short-term bonds called ‘money market instruments’. This is essentially banks lending money to each other.
But the list doesn’t stop there. There are various sub-classes which we can bring into the equation. We tend to turn to these if you have specific desires over which types of companies or market sectors you’d like to invest in.
- Specialists: a sub-class of equities, funds are invested in a specific market sector. These can bear a higher level of risk than other asset classes because they’re not diversified outside that market sector.
- Technology: another sub-class of equities, you’re investing specifically in technology companies.
- Commodities: similar to the properties class, in that you’re investing in a physical commodity. This could be something like gold, oil or even cows. You’re essentially betting that the future price of the asset will be higher than the current price.
As an investor, it’s not essential that you understand the ins and outs of all asset classes. It is, however, important to understand the relative risks associated with each.
A couple more things…
It’s really important to remember that no investing is risk-free. Whilst asset allocation can help mitigate risks, there are no guarantees that you will always see a positive return.
Having said that, getting your asset allocation right from the beginning is one of the most important decisions you will make as an investor. Not only that, it pays to review your asset allocation from time to time. Changes in your life, and in the markets, might mean that it’s wise to shift your asset allocation to a less, or more, risky strategy over time.
That’s why getting professional help with your asset allocation strategy could be the best choice you can make as an investor.
The value of investments and income from them may go down. You may not get back the original amount invested. Some funds will carry greater risks in return for higher potential rewards. Investment in emerging market funds can involve greater risk than is customarily associated with funds that invest in developed, more established markets. Above average price movements can be expected and the value of these funds may change suddenly.
The property market can be illiquid; consequently, there can be times when investors in property funds will be unable to sell their holdings. Property valuations are subjective and a matter of judgement.