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What is asset allocation?

Asset allocation is a term that many investment professionals use. However, many amateur investors may not fully understand it. Our guide to asset allocation not only defines asset allocation but explains why it is a vital investment strategy to use.

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What is asset allocation?
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Fund managers and investment professionals will often bandy around complicated terminology. It can leave the Average Joe a bit lost when it comes to understanding what a financial adviser is saying. Yet, it is critical to comprehend fully how your money is invested. Getting to grips with the language that a financial adviser uses is, therefore, vital. Of course, it is easy enough to ask them directly, but it can be hugely beneficial to understand a few key and common terms. Doing so can ensure that your money is invested where and how you want it to be - with no room for it being lost in translation.

Here, we look at the phrase asset allocation. Asset allocation is a strategy implemented in one way or another by the majority of investment professionals. By defining it, we also address why you need to use it in your portfolio and how you can achieve it. 

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What does good asset allocation look like?

Asset allocation, in short, is a type of investment strategy. Good asset allocation should, therefore, result in higher returns with minimised risk. Asset allocation seeks to achieve this by investing in different asset classes in certain amounts. All the while, a portfolio still needs to meet a person's risk profile and investment timeline.

Asset allocation usually concentrates on the following main asset classes:

  • Equities
  • Bonds (or fixed-income investments)
  • Cash or cash equivalents

However, it can also take into consideration alternative investments, commodities or even gold.

Why do I need to implement asset allocation in my portfolio?

Implementing an asset allocation strategy into a portfolio is a way of minimising risk. Like portfolio diversification, it attempts to invest a person's money so that potential losses are reduced. By ensuring that you have invested in different assets, you can mitigate the risk of losing all your money. For, stocks and bonds react to market movements differently.

However, it is more than just diversifying your portfolio to help reduce risk. Asset allocation is also important due to your investment goals and when you need to meet them. Many of us will be saving for a pension - but the time until we retire will influence how we should allocate our assets.

If you have many years to reach retirement age, your portfolio can be far more heavily invested in stocks or other, riskier assets. The reason being is because you can recoup any losses you make due to market fluctuations. Consider the year of the financial crisis, for example. That hit stock markets exceptionally hard. However, if you had invested money in stocks before this, you would have benefited from previous gains. More importantly, you have had all that time since to regain the losses you may have made.

In comparison, asset allocation when you are nearing retirement age is very different. Your asset allocation strategy will likely be more heavily weighted in fixed-income investments. The reason being is that you cannot withstand losses as easily. You have far less time to recoup them, and you will need to access your pension pot soon.  Fixed income is therefore preferred in such instances, and bonds are seen as less risky assets. Companies have to repay bonds as they are an outstanding debt. If a company goes bankrupt, it is the bondholders of that company that will have their money returned first. Preferred and ordinary shareholders will come second and third - if at all.

Of course, not everyone will be investing with a view to their retirement. Some will be saving to buy a house, put a child through university or save up for a car. All of these different aims will have subsequent different time horizons. That impacts how assets are allocated.

Finally, portfolios should also have a certain amount of cash on account too. The reason being is that this allows portfolios to be dynamic when it comes to making investments. Without cash to invest quickly, portfolios may miss out on golden opportunities. Plus, if some stocks or bonds have to be sold to raise funds to buy other potential investments, the proceeds may be less than they otherwise could have been. Selling assets before reaching an investment outlook can minimise returns in a portfolio overall.

That being said, having too much cash on account is a bad thing as well. Cash will never earn money just by sitting there - particularly when compared to the returns seen in stocks and bonds. For that reason, allocating too heavily in terms of cash can also have a reductive effect on final portfolio returns.

How to achieve optimum asset allocation

While understanding asset allocation is fairly straightforward, achieving optimum asset allocation is tricky. It takes years of experience or intellectual know-how. For that reason, it is essential to work with a financial adviser when addressing your portfolio's asset allocation.

Doing so will help you when structuring your portfolio in a way that answers your needs, requirements, and risk profile. That's not to say that you should leave it purely up to them. Working closely with them will ensure that you are comfortable with how your portfolio is structured to achieve your aims.

Understanding asset allocation strategy

Understanding asset allocation strategies is one of the critical tools you can arm yourself with when investing. Investing according to your needs is crucial, particularly when it comes to retirement. Good asset allocation means you materially improve your chances of reaching your investment aims. That is because effective asset allocation will be done with reference to your investment timeline and risk profile. Both are two fundamental ideas you should always keep in mind when investing.

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