Investing: What is asset allocation? And why is it important?

Karl 31st Aug 2023 No Comments

Reading Time: 5 minutes

Risk can never be eliminated entirely when investing, even if you feel your portfolio is as safe as houses.

In this article we’re going to dive into the world of asset allocation, breaking down what it means, and how effective asset allocation can help to reduce your exposure to risk.

Keep on reading for all the details, or click on a link below to jump straight to a specific section…

What is asset allocation?

Asset allocation refers to spreading out your investments across different types of assets, such as equities/shares, bonds, cash, commodities, property, or other alternative investments. The goal of asset allocation is to balance risk and reward by broadening your investments across different types of assets that have historically exhibited varying levels of correlation to one another.

For example, as a rule of thumb, bonds and equities have an inverse relationship. So when equities rise, bond prices usually fall. This is because during a stock market rally, many investors will be keen to ‘get in on the action’ by piling their capital into equities in order to benefit from rising stocks.

On the flipside, when equities fall, bond prices typically rise. That’s because bonds are considered a safer, less volatile investment class. It’s the reason why bonds are often the go-to for investors during challenging economic times.

Being comfortable with risk

We know that holding a mix of investments can help to reduce the overall risk of your portfolio. However, the question of ‘how much risk you should take on’ is a very personal decision for all investors.

Before you invest you should know exactly how much risk you’re comfortable with as this should ultimately help you determine how to mix and match assets.

Let’s break this down further…

Are you willing to chase higher returns at the risk of seeing the value of your portfolio plummet? If that’s you, then you may wish to allocate a large proportion of your portfolio towards equities. Typically, equities deliver higher returns than other asset classes over time, but they’re also more volatile.

However, if the thought of losing a significant chunk of your wealth keeps you awake at night then you’ll almost certainly want to keep your exposure to equities to a minimum. To put it another way, if you’re risk-averse, you’re likely to prefer holding bonds or other less-volatile assets.

The 60/40 portfolio

Many investors finding themselves in the middle of the risk-tolerance chart may wish to turn to the 60/40 ‘tried and tested’ equities and bonds allocation.

The term ’60/40′ refers to 60% of your portfolio being invested in equities, and 40% in government bonds. The idea behind this allocation is that it gives a good balance between the opportunity of higher returns, while maintaining a decent ‘cushion’ from the exposure to bonds.

On this point, it must be said that the 60/40 has come under fire over the past few years thanks to the allocation’s recent poor performance. In 2022, the 60/40 allocation suffered its worst performance in 23 years.

However, the bond market has picked up in 2023 with equities generally underperforming, so far at least. With this in mind, there is a chance that 2022 was a just a blip along the road for the 60/40 portfolio.

Of course, if you want to mix up your portfolio with equities and bonds, then there’s no obligation to go with a 60/40 split. Depending on your appetite for risk, you may prefer a 80/20 split in favour of equities, a 50/50 holding, or even a 90/10 split in favour of bonds. There really is no right or wrong answer.

The importance of rebalancing your portfolio

Let’s say you’ve determined your tolerance for risk and you’re keen for a portfolio consisting of 60% equities and 40% bonds.

For this example we’ll assume you have £50,000 to invest.

You buy £30,000 worth of shares via an investment broker and £20,000 of government bonds/gilts via the HM Debt Management Office.

While there’s nothing inherently wrong with putting together a portfolio in this way, if you manually buy shares and bonds yourself then it’s important to consider the importance of rebalancing your portfolio on a regular basis.

For example, say three months down the line your equity holdings rise by 10%, but your bonds fall 10%. You’d be left holding £33,000 worth of shares, and £18,000 worth of government bonds which would equate to a 65/35 portfolio.

While you might feel this is nothing to be concerned about, if you wanted to maintain a 60/40 allocation, you’d have to offload some shares, and buy more bonds. If you didn’t, you could see your portfolio continue moving away from your original intended allocation. This means your portfolio could soon find itself sitting outside of your appetite for risk.

Of course, buying, selling and re-buying shares/bonds can be laborious and potentially costly. Thankfully, however, there is a way to overcome this.

Readymade investment funds, such as Vanguard’s LifeStrategy funds, allow investors to choose a suitable asset allocation, without having to go through the faff of buying and selling shares. That’s because these funds automatically rebalance your portfolio on your behalf, so you don’t have to worry about your asset allocation falling outside of your tolerance for risk.

For more on these funds and how they work, take a look at the Vanguard website.

The difference between asset allocation and diversification

Now we’ve explained the ins and outs of asset allocation, you may be wondering how it differs from diversification.

As mentioned above, asset allocation refers to spreading out your investments into different assets, whether that’s equities, bonds, commodities, property or anything else.

While diversification may also refer to mixing up your assets, it can also refer to diversifying your investments within those different asset classes.

For example, say you choose a portfolio consisting of 30% equities, 30% bonds, and 40% commodities. While you’ve already determined your asset allocation, you now need to choose which shares and commodities to buy.

In this scenario, if you’re a well-diversified investor then you may choose to buy shares in a mixture of established companies and startups across multiple sectors. You may also wish to spread out your commodity investments across different industries. For example, rather than putting all of your faith in the energy sector, you may decide to have exposure to agricultural products and precious metals. By doing this, you’ll be able to minimise the risk of your portfolio taking a big hit should one particular industry or sector encounter a challenging year.

To learn more about this topic, take a look at our article that explains the importance of holding a diversified portfolio.

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