Are you familiar with the phrase “never put all your eggs in one basket?” I bet you are. That’s the simplest definition of asset allocation.
In financial terms, asset allocation is an investment strategy that aims at balancing your portfolio’s risk versus returns by spreading assets among major asset classes in various proportions.
Common Asset Classes
1. Equities / Shares/ Stocks
Equity investment is money you put towards purchasing shares in a company. Because share prices depend highly on the large movements in the market daily, equities are considered as risky assets.
The higher the volatility of the stock prices, the higher its risk. Equities mostly perform well in a growing economy, but the opposite is also true.
2. Fixed Income
Fixed income investments derive their name from the fact that they’re usually designed to generate a specific, or “fixed,” level of interest income. Fixed income investments include bonds, certificates of deposits, and mortgage-backed securities.
The performance of a fixed income asset depends on the quality of the issuer. That is why government bonds are considered more secure than corporate bonds. Bonds also tend to be relatively more stable than equities and provide more regular interest income.
Learn more in a related post: How to Invest in Kenya Government Securities
3. Cash and Cash Equivalents
Cash and its equivalents are the most liquid of assets. These are short-term investment securities with maturity periods of 90 days or less. Common examples of cash and equivalent investments are bank deposit certificates, Treasury bills, commercial paper, and money market instruments.
Though they have low returns, they are very liquid and are ideal for short term investments. These are also ideal for building an emergency fund.
Other alternative assets include Real estate/properties and commodities such as oil and gas, silver and gold that have found their way as merchandise in the Global Market.
Learn more in a related post: Types of Investment Assets in Kenya
Factors That Affect Asset Allocation
1. Risk Profile
Refers to how much an individual is able and willing to lose a given amount of their original investment in anticipation of getting a higher return in the future. Risk-averse investors would prefer to build their portfolios in more secure assets.
On the contrary, more aggressive investors are willing to risk most of their investments in anticipation of higher returns. Risk-averse investors will have a higher allocation in low-risk assets like bonds and a low allocation on high-risk investments like stocks.
The younger generation may prefer to invest in assets with high returns, however risky. Since stocks are ideal for long term investment of over 5 years, it allows younger investors to recoup from the market volatility while enjoying higher returns.
However, as one nears retirement, it is advisable to have a portfolio with low-risk investments to preserve capital and also have access to regular income.
3. Financial Goals
These are individual objectives to achieve a given level of return or saving for a particular purpose or desire. Different goals thus affect how individuals invest and their ability and willingness to take risks. For example, cash and equivalent investments like money market funds are ideal for short term financial goals of one year or less.
4. Time Horizon
This refers to how long you are willing to invest before withdrawing your money. Investor’s time horizon mostly depends on their financial goals. Different time horizons present different risk tolerance.
If you are saving for your vacation when the pandemic ends, that is a short time horizon. Investing for retirement or such goals that actualize in 10 to 40 years from now, that is a long time horizon.
How does this affect your asset allocation strategy? For instance, a long time horizon may increase an investor’s risk tolerance, allowing them to invest in more volatile assets. On the other hand, investors with short-term goals will probably prefer to allocate the highest percentage of assets in their portfolios to less-risky assets.
Related article: What Are Hybrid Funds And How to Invest in Them
Advantages of Asset Allocation
- Diversification – helps investors minimize risk for a given time frame by investing in varied classes of assets, thereby diversifying their portfolio.
- Better returns – asset allocation exposes your portfolio to numerous asset classes, enhancing your returns during any market cycle.
- It helps one focus on long term investing rather than basing your portfolio investments on temporary volatility of the market.
Asset Allocation Versus Portfolio Diversification
While asset allocation is one of the strategies that allow you to diversify your portfolio, it is different from diversification.
For example, with the percentage of equities allocation in your portfolio, you can diversify further by investing in stocks from large, mid, and low-cap companies instead of accumulating equities in large-cap companies only. If you are investing in bonds, you can mix it up with government and corporate bonds. The goal of diversification is to have assets with low correlations in your portfolio.
Remember that assets with low correlations perform differently in various market conditions. There are times when some investments will do well when others are performing poorly. Asset allocation will only help you to achieve diversification if you allocate assets with low correlation to mitigate market volatility risk.
When investing, I would advise you to consult a financial advisor. After determining your risk tolerance, investment goals, and time horizon, your financial advisor can draw an investment strategy with asset allocations that meet your objectives and return goals.