Asset allocation is part of the top-down approach to wealth management, leading to investment in individual countries, sectors, etc. As we will cover in a moment, selecting the correct asset allocation is crucial in the short, medium and long-term and will significantly impact returns. We will now look at the different asset classes and how the allocation of your investments will change during your life.
Different types of asset class
Before we look at the importance of asset allocation, we need to appreciate the three main asset classes, which are:
- Equities
- Fixed income
- Cash and equivalents
Within each of these classes, subclasses will offer varied approaches to risk and reward. You will often hear the term asset allocation used in tandem with diversification, a case of “not putting all of your eggs into one basket”.
Young investor
As a younger investor with one eye on the future, you may look for higher equity exposure instead of fixed income, cash and equivalents. This will allow you to take a long-term approach to growth, a timeframe not available to everyone. If you look over the various cycles of the stock market, the long-term trend tends to be upwards.
Investment in equities is the best way to tap into growth markets, but nothing is guaranteed, as we saw with the 2008 financial crisis and the Covid pandemic.
Middle-aged investor
As we get older, we begin to look towards retirement and ways to fund our lifestyle as employment income starts to recede. Consequently, middle-aged investors are looking to reduce equity exposure and inject stability in the shape of fixed-income assets and maybe a little extra cash and equivalents.
When approaching retirement, we tend to look for more stable assets, but very often, there is reduced potential for growth. However, executed correctly, this also creates heightened protection for existing assets.
Retirement
To a certain extent, there is more focus on the younger generation and those approaching retirement than those in retirement. In reality, those in retirement still need financial advice to maximise their returns and support their income. While it is common to see a switch out of equities into more fixed income and liquid assets, it does depend on the individual’s situation.
We usually see a gradual switch from more volatile equities to income-producing assets and increased liquidity. This means funding should be available as and when required at short notice when in retirement.
Gaining exposure to different asset classes
The next level below asset allocation is an investment in individual investments such as companies, collective funds and bonds. You may have the skills and expertise to pick individual investments and make an above-average return. However, in most cases, those with limited market experience tend to go for mutual funds or EFTs.
When studying the performance of an individual asset manager, you should look for a degree of outperformance in a perfect world but not volatile performance. For example, funds outperforming the market by 10% one year and underperforming by 10% the next are not necessarily stable investments.
Diversification is the key
Many day traders can make significant regular returns with short-term investments. However, this is not the norm unless you have the skills, time, and money to watch and study markets. Asset allocation is the key to long-term performance, finding suitable asset classes and the right assets to invest in.
Summary
Asset allocation without diversification can often lead to volatile returns, sometimes out of sync with the underlying sector/market. This is why many people look towards collective funds and EFTs, which provide a broad spread of investments across particular sectors and markets. Your financial adviser will have access to performance figures, market research as well as experience in varied market conditions, invaluable as we have seen in recent years.