Asset allocation involves dividing investment funds into asset classes, including cash, bonds, property, and shares. Spreading investments across various asset classes can help diversify the portfolio’s holdings, which is critical for managing risk.
In theory, asset classes rise and fall at different times. So, when one asset class increases, 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 by reducing volatility from being invested in a limited range of asset classes.
Different approaches to asset allocation
Allocating your investments can involve many different strategies. Your choice will often depend on your life stage, risk appetite, and 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 option is sensible if you don’t want to risk losing money.
Many people with substantial wealth use this strategy because they don’t need to risk their capital to produce a return, given that they already have sufficient funds to support their lifestyle.
When using a capital preservation approach, investors tend to put most of their funds in cash or low-risk investments like government bonds. While this may be an excellent way to protect your capital, your returns will likely be modest. It’s also essential to assess whether there’s a risk of inflation reducing the purchasing power of the original principal amount, should the resulting returns be below inflation. In this case, the strategy should be reviewed to ensure the funds in the portfolio are preserved and not falling in absolute value.
Income generation
People nearing retirement or in retirement who are no longer working and producing a regular salary may choose an asset allocation strategy focused on producing income and cash flow to support their lifestyle.
The type of investments used in this strategy produces a regular, often fixed income. They could include government and corporate bonds, real estate investment trusts and some shares that generate more robust or at least consistent dividends.
This approach to asset allocation may generate a higher return than a capital preservation strategy because of the exposure to other asset classes. However, the strategy’s performance will be lower than that of different strategies through which investment income 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 primarily 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, while others tilt their asset allocation one way or another. If you choose a balanced asset allocation approach, it’s essential to read your fund’s asset allocation strategy so you understand and are comfortable with how your money is invested.
Growth strategy
In an asset allocation strategy tilted to growth, portfolios will likely have higher-risk assets, such as shares and property, which can generate higher returns over time.
This strategy is often used by younger people who wish to generate wealth over time and who have the time and, therefore, the ability to ride our market cycles.
Strategic versus tactical asset allocation
The approaches outlined above are usually known as strategic asset allocation. They 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 investment funds or portfolio pools. In this approach, fund managers will opportunistically decide to change how 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 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 weigh the fund to take advantage of market conditions, hopefully cushioning returns from market fluctuations. Still, they must ensure the fund’s assets remain broadly aligned with the bands above. Unsure if you have your asset allocation strategy approach right? Speak to the team at Everalls Wealth Management to ensure that your asset mix is in alignment with your financial goals.
Source: BT
