Asset allocation is the process of dividing funds between different asset classes including cash, bonds, property and shares. This takes place as spreading resources across different asset classes can help diversify the portfolio’s holdings, which is an important way to manage risk.
In theory, asset classes rise and fall at different times. So, when one asset class rises another will fall, and vice versa. It’s not a perfect relationship but over time this relationship can help smooth out your portfolio’s returns.
Different approaches to asset allocation
There are many different ways to allocate your investments. The right choice will often depend on your life stage, your appetite for risk and your investment goals.
Capital preservation funds
Investors often choose this strategy if they need to access their money in the next 12 months, for example if they wish to use the funds as a deposit to buy a home. This can be a sensible option if you don’t want to risk losing your money.
Many people who already have substantial wealth use this strategy as they don’t need to risk their capital to produce a return given they already have sufficient funds to support their lifestyle.
Taking a capital preservation approach, investors tend to put most of their funds in cash or very low risk investments like government bonds. While this may be a good way to protect your capital, your returns are likely to be modest. It’s also important to assess whether there’s a risk of inflation reducing the principal amount, should the strategy’s returns be below inflation. In this case, the strategy should be reviewed to ensure the funds in the portfolio are actually preserved and not falling.
Income generation
People nearing retirement or in retirement, who are no longer working and producing a regular salary, may choose an asset allocation strategy to produce income to support their lifestyle.
The type of investments used in this strategy produce a regular, often fixed income. They could include government and corporate bonds, real estate investment trusts and some shares that may generate stronger dividends.
This approach to asset allocation may generate a higher return compared to a capital preservation strategy. Keep in mind however, the strategy’s performance will be lower than other strategies through which income produced from the investments is reinvested to generate additional returns.
Balanced strategy
In a balanced asset allocation strategy, a mix of different asset classes produces growth and income for the fund. Resources are largely split between fixed interest investments and shares, with a smaller allocation to other asset classes such as cash and alternatives, providing both protection and diversification.
There are many different types of balanced funds. Some split their resources evenly between shares and fixed income investments. Others tilt their asset allocation one way or another. It’s important to read your fund’s asset allocation strategy so you understand and are comfortable with the way your money is invested if you choose a balanced asset allocation approach.
Growth strategy
In an asset allocation strategy that is tilted to growth, portfolios are likely to have higher risk assets, such as shares and property, which also offer the potential to generate higher returns over time.
This strategy is often used by younger people who wish to generate wealth over time, and who have the ability to ride our market cycles.
Strategic versus tactical asset allocation
The approaches outlined above are usually known as strategic asset allocation and involve changing the fund’s weighting to different asset classes, depending on the investor’s ability to tolerate risk, their time to retirement and investment goals.
Tactical asset allocation is another way to split resources into different pools in an investment fund or portfolio. In this approach, fund managers will opportunistically decide to change the way the assets in a fund are invested, depending on investment market cycles.
For instance, let’s say the share market experiences a substantial fall. Some fund managers will choose to allocate more money to shares after this correction, assuming the market will rise and the fund will benefit as share prices lift. The same approach can be used across any asset class.
Fund managers can use both a strategic and tactical approach to asset allocation in the same fund. For example, if a fund has a balanced approach the fund manager may have a mandate to allocate the fund’s resources in the following bands:
- Cash 0% – 10%
- Fixed interest 40% – 50%
- Shares 40% – 60%.
Fund managers can choose to weigh the fund to take advantage of market conditions, hopefully cushioning returns from market fluctuations, but they must ensure the fund’s assets remain broadly in line with the bands above.
Source: BT