A commonly used term – but what does it really mean?
So, asset allocation. It’s so ingrained in how we manage our clients’ investment portfolios, that we talk about it all the time.
So, what is it? What are assets? And what happens when you allocate them?
The big picture
An asset is anything beneficial you have or you have coming to you.
For our purpose, it’s anything of value in your investment portfolio. After bundling your investible assets into asset classes, we then allocate or assign each asset class a particular role in your portfolio.
To offer up an analogy, allocating your portfolio into different asset classes is similar to storing your clothes according to their roles, so your trousers, your shirts, your shoes, et cetera. Instead of just leaving them in a big pile in your wardrobe, that you kind of sort them out.
You may also further to sort your wardrobe by style, so you create ideal kind if outfits for your various circumstances. For argument’s sake, I have some clothes that I’ll do the gardening in, I’ll have some clothes for the weekend, clothes for the office, clothes for possibly a wedding, going out, et cetera. I suppose they’re hung in different parts of my wardrobe, and the shoes are kind of a certain order as well.
Likewise, I suppose asset allocation helps us tailor your portfolio to best suit you, efficiently tilting your investments towards or away from various levels of market risks and expected returns. Your precise allocations are guided by your particular financial goals.
That’s it, really. If you stop reading here, you’ve already got the basics of asset allocation. Of course, given how much academic brainpower you’ll find behind these basics, there is a lot more I can cover. For now, let’s just a closer look at asset classes.
A closer look at asset classes
So, what have we got?
- At the broadest level, asset classes typically include domestic, developed, international, and emerging market versions of equities, which is the same as shares or stocks, which is an ownership or a stake in a business.
- Bonds, or another word is fixed income, which is a loan to a business or government.
- Hard assets, which are kind of a stake in a tangible object, such as it could be commercial property, it could be gold, or oil, or something of that type.
- Cash or cash equivalence, so cash just in the building society, in the bank, within your pension fund, which is then invested within the bank accounts, or very, very, you could say a proxy for cash could be very short one-month duration bonds to the U.K. government, let’s say, if you were a U.K. investor.
Just as you can further sort out your wardrobe style, each broad asset class, except for cash, can be further subdivided based on a set of factors or expected sources of return.
For example, stocks and shares can be classified by company size: small companies, mid-sized companies, large cap companies, business metrics, value, or growth, and a handful of other factors more recently identified.
Bonds can be classified by types, so government bonds, corporate bonds, and then there’s a credit quality, high or low ratings, and then the term. Loans for a short-term, intermediate-term, or long-term, I.e. when they’re repaid.
Now, we can mix and match all these various factors into a manageable collection of asset classes, such as international small company shares, or intermediate government bonds, and so on.
Generally speaking, the riskier the asset class, the higher return you can expect to earn by investing in it over the long haul.
Implementing our understanding
Whilst we understand the asset allocation, we’ve got to implement it. We’ve got to turn the plan into action.
This is where we turn to select fund managers with low costs, who will track our targeted asset classes as accurately as possible. Now, sometimes a fund tracks a popular index that tracks the asset class, and other times asset classes are tracked more directly. Either way, the approach lets us turn of a collection of risk/reward building blocks into a tightly constructed portfolio with asset allocations optimised to reflect your individual investment plans.
Now, who decided which asset classes to use based on which market factors?
Well, to be honest, there’s no universal consensus on the one and only correct answer to this complex and ever-evolving equation.
As evidence-based practitioners, we turn, that’s us here at MFP, turn to ongoing academic inquiry, professional collaboration, and our own analysis. Our goal is to identify allocations that seem to best explain how to achieve different outcomes with different portfolios.
As such, we look for robust results that have been replicated across global markets, been repeated across multiple peer-reviewed academic studies, lasted through various market conditions, and actually worked, not just in theory, but as investible solutions, where real life trading costs and other frictions apply.
Aligning asset allocation to long term goals
Now, as we learn more, and sometimes we improve on our past assumptions, even as the underlying tenets of asset allocation remain our dependable guide, the bottom line, by employing sensible evidence-based asset allocations reflect your unique financial goals, including your timeline and risk tolerance, you should be much better positioned to achieve those goals over time.
Asset allocation also offers a disciplined approach for staying on course towards your own goals through ever volatile markets.
Now, this is more important than most people realise.
Where people get killed is getting in and out of investments. They get halfway into something, then they lose confidence, and then they try something else, and then they lose confidence, and then they try something else. It’s actually better off to have a philosophy and stick to it.
Hopefully, now that you’re a bit familiar with asset allocation, and I hope you agree that properly tailored, it’s a fitting strategy for any investor seeking to earn a long-term market return.
You can hear me explain more about asset allocation on episode 031 of The Retirement Café Podcast.