Definition

Asset allocation refers to the strategic distribution of an investment portfolio across different types of assets, such as stocks, bonds, cash, real estate, and other investment vehicles.

What is asset allocation?

The goal of asset allocation is to create a diversified portfolio that balances risk and potential returns based on an investor’s financial goals, risk tolerance, and time horizon.

Diversification through asset allocation involves spreading investments across various asset classes and sectors. This approach aims to reduce the impact of poor performance in any single investment on the overall portfolio. Different asset classes have varying levels of risk and return potential, so a well-thought-out asset allocation strategy can help manage risk while aiming for long-term growth.

Investors may adjust their asset allocation over time to align with their changing financial situation and goals. For example, a younger investor with a longer time horizon might have a higher allocation to higher-risk assets like stocks, while an older investor closer to retirement might prioritise more conservative investments like bonds.

Effective asset allocation requires careful consideration of an individual’s financial circumstances and investment objectives, and it plays a crucial role in achieving a balanced and successful investment strategy.

Example of asset allocation

Sarah, a 30-year-old investor, has a moderate risk tolerance and a long-term investment horizon of 30 years until retirement.

1. Asset allocation strategy:
   • Given her long investment horizon and moderate risk tolerance, Sarah decides on a diversified asset allocation strategy:

   a. Equities (Stocks):

   • Sarah allocates 70% of her portfolio to a mix of domestic and international stocks. This includes individual stocks and equity mutual funds.

   b. Fixed income (Bonds):

   • She allocates 20% of her portfolio to bonds, providing stability and income. This includes government and corporate bonds.

   c. Cash and equivalents:

   • Sarah keeps 10% of her portfolio in cash and cash equivalents for liquidity and to seize investment opportunities that may arise.
2. Asset allocation breakdown:
   • Sarah’s asset allocation breakdown looks like this:
     • Equities: 70%
     • Fixed Income: 20%
     • Cash and Equivalents: 10%
3. Rebalancing:
   • To maintain her desired asset allocation, Sarah periodically reviews her portfolio and rebalances it. For instance, if the stock market performs exceptionally well and the equity portion increases beyond 70%, she might sell some stocks and reallocate funds to bonds and cash.