Asset allocation is one of the most important aspects of investing. It’s up there with deciding on what actual assets to invest into in the first place. Many investors around the world find themselves focusing too much on their individual holdings and their performances, and fail to take a step back to look at the big picture.
What is asset allocation?
Asset allocation refers to the combination of different asset classes within an investment portfolio, and how much each asset class makes up of that portfolio. In simple terms, there are three main asset classes (not including real estate):
- Equities (also known as shares)
- Fixed income (commonly referred to as bonds)
Check out 5 Low-Risk Investments Every 20 Something Must Know Of – Pt.1 for more information on these assets.
Each asset class has a different level of risk associated with it. For example, since the stock market can be very volatile in the short term, equities have a higher risk. Cash, on the other hand, is a very safe investment. But the returns are generally much lower than that of equities.
So what is the right asset allocation for you?
There are numerous factors to take into account when choosing the right asset allocation for your portfolio. If you are in your 20’s or 30’s for example, you have more flexibility to expose yourself to more short-term risk as you aren’t nearing retirement. This typically means you can have a larger amount of your portfolio in equities. If you are nearing retirement and require access to your funds in the near future, you would generally want to expose yourself to less risk. This means you’d have more bonds or cash in your portfolio.
A common rule of thumb to determine how much of your portfolio should be invested in shares is to subtract your age from 100, and that is the percentage of your portfolio that should be invested in shares.
For example, if you’re 25 years old, this rule would dictate that you should invest 75% of your portfolio in shares, and the remaining 25% across other asset classes with less risk. This is because you can expose yourself to more short term risk in the stock market when you are younger.
Here is an example of a more aggressive investment portfolio of an investor who is in their 20’s:
In contrast, here is an example of a portfolio of someone in their mid-fifties, planning to retire in 5-10 years:
The biggest factor when deciding your ideal asset allocation is how much risk you can expose your money to in the short to medium term. Another common rule is not to invest any money in equities that you may need in the next 5-10 years.
The common mistake that most investors make with their asset allocation strategy
An important thing to remember is that the value of different asset classes increases and decreases. Your asset allocation will change slightly based on this increase or decrease in the value of the particular asset.
To explain this in simple terms, let’s consider an investment portfolio of $10,000 that is split 50/50 between cash and stocks ($5,000 in stocks and $5,000 in cash).
If your stocks all exactly double in value, while the value of your cash remains at $5,000, this would bring the total value of your stocks to $10,000 and the entire portfolio would now be $15,000.
Because of this, the asset allocation has changed from an even 50/50 spread to now 2/3 in shares (the shares are now valued at $10,000) and 1/3 of the portfolio in cash (the value remained at $5,000)
If this investor wants to retain their 50/50 split between shares and cash, they need to do something called rebalancing. This means either adding more money in cash to balance it out, or selling part of their shares and using that money to put into cash to bring it back to a 50/50 split. The beauty of rebalancing is that it forces you to buy low and sell high, which is the holy grail of investing.
Rebalancing can be complicated, so we will be writing another article shortly that goes into further detail about rebalancing and how to do it, so stay tuned!
Key takeaways to remember
The most important things to consider when deciding on your individual asset allocation can be broken down into two points.
- Determine how much risk you can expose yourself to and;
- Determine how far away you are from retirement.
If you think you may need a large sum of money in the near future (whether it be for a house deposit, a wedding, or your retirement), having a stronger proportion of your portfolio in lower-risk assets like fixed income or cash would be a wise decision.
On the other hand, if you’re in your teens, 20’s or 30’s and have a sum of money that you won’t necessarily need in the next 10 – 20 years, investing more in equities to maximise your long-term returns might be a good idea.
Paying close attention to the individual assets you invest in and how much they make up your portfolio is crucial. If you can manage that, you’ll be well on your way to future financial success and security.
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Disclaimer: This website (the “The Money Pal”) is published and provided for informational and entertainment purposes only. The information in this Blog constitutes the Content Creator’s own opinions and it should not be regarded as financial advice.