By Edward Rayner and Josh Coley
What is asset allocation?
Asset allocation is the process of deciding which asset classes, for example equities, bonds, or cash, to invest in. This decision is a key consideration for investors and can change several times over the life cycle of an investment portfolio, often being a main determinant of a portfolio’s overall returns and risk premium.
How to determine asset allocation?
An investor’s objectives from a portfolio and the time horizon to achieve these is one of the major determinants of asset allocation. An example is an investor saving for a new car next year, and another saving for a house deposit they intend to use in ten years’ time. While the car saving investor may focus on investing in more conservative assets with less short-term value fluctuations like bonds, the house deposit saver may concentrate on more aggressive assets like equities, due to their ability to ride out near term value headwinds over the long run, which the shorter-term investor cannot do.
Another key asset allocation consideration is an investor’s required rate of return to reach their portfolio’s goals. An investor may have a set future value they want for their portfolio, as example being a certain house deposit value in ten years, and thus can derive the per annum return they need to reach this, given their portfolio’s timespan. The question then becomes how much risk the investor is willing to accept to achieve this return, with assets such as equities and cryptocurrency often having more risk and thus requiring a higher risk tolerance, while assets like bonds require less.
Although their short/long term goals, expected return and timeframe may differ, one thing that most knowledgeable investors have in common is that they are risk-averse. In short, this means that they wish to make their desired amount of money from an investment without taking on any more risk than they absolutely have to (minimal downside risk profile) and thus, will always invest in the asset class with the lowest possible risk attached for their expected return.
As a result, many investors seek to diversify their portfolio across a number of asset classes to protect themselves from the risk associated with investing money. The main idea behind diversification is that by investing in multiple securities/asset classes, an investor is reducing the effect of one investment upon their overall return should it go down; meaning that in most cases, their losses (if not nullified by other classes increasing in value) would be much less than if they were to allocate all available money into a singular asset class.
However, relating this back to the idea of asset allocation, the main challenge for the investor is how much money/weighting of their portfolio should they place into a singular asset class. This largely depends on their propensity for risk and level/time period in which they expect to see returns. For example, someone who wishes to see large returns in the short term (something which cannot be achieved without a relatively high level of risk) will weight their portfolio heavily into more volatile asset classes such as cryptocurrency than someone with a more long-term-minded portfolio.
For those aiming to get into the investing game, or even those already playing, it is critically important to understand and continue to evaluate both your investing goals, and your propensity to take on risk. While this will certainly not guarantee success, it will increase the probability of a good outcome.
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