Everything you need to know about asset allocation, including where to place your money and why having a diverse selection of investments in your portfolio is so crucial.
What exactly does asset allocation entail?
The act of distributing your investing capital over a variety of assets, such as cash, bonds, shares of stock, and property, is referred to as asset allocation.
This strategy reduces exposure to risk by increasing diversification; in other words, it ensures that all of one’s eggs are not placed in the same basket.
Both the potential for growth of your investments and the level of risk that you are willing to take are impacted by the kinds of assets you have in your portfolio as well as the percentage of your total holdings that are allocated to each.
In this section, we will discuss how to select the assets that are appropriate for your investment objectives.
Where should I put my money?
Investments are typically categorised as falling into one of the following categories:
Putting money into a company either by purchasing individual shares or by doing so through a fund that specialises in equity investments or an investment trust.
Although it depends on the specific firm, industry, and region, equity investments are typically considered to have the biggest risk as well as the potential for the greatest gain.
Gold and government bonds
Bonds issued by corporations represent a fraction of loans granted to certain corporations. Even though they typically carry a lower level of risk than equity investments, there is always the possibility that the company could fail and you will lose all of your investment. The yield that you might expect to receive is typically a reflection of the risk that you are taking on.
Loans given to governments are known as government bonds; in the United Kingdom, these bonds are referred to as Gilts.
Here you can learn more about the investments known as “fixed income.”
Rental revenue and appreciation in the value of the property that you own can both contribute to the increase of your wealth when you make an investment in commercial real estate, such as an office building, a grocery store, or a warehouse.
On the other hand, some investments can be illiquid, which means that it might be difficult to sell them if you suddenly needed the money. This is true not only for the real estate that you personally own, but also for the investments that you make through real estate-focused investment funds, some of which have been shut down in recent years.
It is essential to keep some money on hand that can be accessed quickly in case of an emergency.
However, if you keep a significant portion of your portfolio in cash, then your purchasing power would gradually decrease as a result of inflation.
Instead of putting cash into an ISA that invests in stocks and shares, you should put it into a cash ISA or a savings account so that it might earn interest.
Golden and silver bullion
Investors place a high value on gold and, to a lesser extent, silver because of their potential for long-term growth, particularly during times when investments in equities are performing poorly.
However, there is no assurance that the prices of gold and silver would continue to go up in the future.
You won’t see any profits until you sell the metals, and you’ll have to pay to store them if you want to keep them. Neither of the metals provides a yield.
Here you may learn more about investing in precious metals like gold and silver.
There are many other sorts of investments, such as commodities, peer-to-peer investments, and cryptocurrencies; however, these types of investments are less suited for average investors and, in most cases, shouldn’t make up a significant amount of your portfolio.
What exactly does the term “diversification” refer to?
It is necessary to invest in assets that perform differently from one another if you want to get the benefits of diversity.
Each category of assets has a connection to the others, as follows:
high correlation indicates that price changes typically occur simultaneously. Shares of companies operating in closely connected industries might be included.
low correlation indicates that there is very little or no association between the variables. Has frequently comprised both shares of stock and bonds issued by the government, particularly when the two are located in different nations.
negative correlation, which means that their movements are inversely proportional to one another. For example, the price of gold tends to rise in tandem with a decline in market conditions.
When you diversify the risk of your investments among a variety of assets, you cut down on the likelihood of incurring significant losses. If you had all of your money invested in a single asset, industry, or region, and that asset, sector, or region started to lose value, your investments would suffer as a result.
When you diversify your portfolio by purchasing assets that are unrelated to one another, even if one portion of your holdings experiences a decline in value, the rest will not be affected in the same manner. When the value of other assets falls, the value of some will actually increase.
Is it possible to have too much variety?
The so-called “unsystematic risk,” which might refer to declines in the value of particular investment sectors, regions, or asset types in general, can be mitigated to some extent through diversification.
However, there are certain occurrences and dangers that diversification cannot protect against, and these are known as systemic risks. These include changes in interest rates, increases in inflation, wars, and economic downturns. It is extremely unusual for every asset class to experience a decline at the same time; nevertheless, as the financial crisis of 2008 demonstrated, this does occur on occasion.
Additionally, diversification does not mean own each and every sort of asset or an equal amount of each asset. Your investment goals and your diversification strategy need to be in harmony.
How can I make my portfolio more diversified?
Step one is to select a variety of assets.
As was just shown, many asset classes each exhibit their own unique pattern of behaviour.
When considering how you might combine different types of assets, our model investment portfolios might serve as a helpful jumping off place for your thoughts.
The second step is to diversify by industry.
Imagine that in 2006 you were a shareholder in a UK bank. It’s possible that your investment yielded a significant return, prompting you to make the decision to buy shares in more financial institutions.
The value of your shares in this industry (financials) would have dropped significantly the following year when the credit crunch occurred, which was the catalyst for the banking crisis.
Therefore, once you have chosen the assets that you want to include in your portfolio, you may further diversify it by investing in a variety of industries and sectors; ideally, you should choose ones that aren’t significantly correlated to one another.
In the event that the healthcare industry has a slump, for instance, this might not necessarily have an effect on the precious metals industry. This helps to ensure that the value of your portfolio is maintained despite declines in specific industries.
Some investors will choose to build their portfolios by directly purchasing shares of particular companies, while others will choose to obtain exposure to a variety of markets by investing in equity funds or investment trusts.
Step 3: Distribute your investments throughout different countries around the world.
It is possible to lessen the impact of fluctuations in the stock market by diversifying one’s investments geographically. This indicates that the economic conditions of a single nation and the economic policies of a single government do not have exclusive influence over you.
You must, however, be mindful that spreading your investments across a number of different geographic zones can expose your portfolio to a higher level of risk.
Emerging markets, such as Brazil, China, India, and Russia, are characterised by greater price swings than developed markets, which include the United Kingdom and the United States. Investing in foreign markets can increase your portfolio’s diversification, but only if you are willing to tolerate higher levels of risk.
Step 4: Invest in numerous firms by purchasing stock in them.
You shouldn’t put all of your money into a single company. It could fall on hard times or possibly fail entirely. Your investments should be dispersed throughout a variety of different businesses.
The same is true for investments in property and bonds. Using an investment fund or investment trust is one of the most effective ways to accomplish this goal.
In order to diversify their risk as much as possible, they will invest in a variety of different stocks, bonds, assets, and currencies. This might be anywhere from 40 to 60 shares in a single country, stock market, or industry if we’re talking about equities.
You might have investments in two hundred different bonds if you use a bond fund. This can help diversify your portfolio and will be considerably more cost-effective than re-creating it on your own.
Be certain that the funds you possess genuinely own separate shares, and that you are not purchasing the same firm through many funds, as this would not help you diversify at all. This can be avoided by ensuring that the funds you own actually own distinct shares.
How should I divide my money between different types of assets?
The amount of time you have available to invest, the amount of growth you need to achieve in order to meet your financial goals, and the amount of risk you are comfortable taking in order to achieve that growth are all factors that should be considered when determining the appropriate asset allocation.
It is essential that your investments represent the maximum amount of money you can stand to lose in the event that market prices go down.
In our introduction to investing guide, we cover several of these concerns in further detail.
If you have the answers to the questions that were presented above, you might find it helpful to peruse our sample investing portfolios for ideas.
You don’t have to make all of the selections on your own if you aren’t sure what you’re doing; a financial adviser may assist you in translating your goals and your overall financial condition into comprehensive investment choices.
Do-it-for-me investment platforms, often known as roboadviser platforms, employ questionnaires to learn about you and then recommend a pre-assembled portfolio of funds.
DIY investment platforms offer blended funds, which are funds that contain other funds, that are created for certain appetites for risk. If you do understand your risk tolerance but do not want to spend time conducting research, you can take advantage of these blended funds.
When should I make a modification to the way my assets are allocated?
Changing the length of your time horizon is by far the most common justification for reevaluating your asset allocation. For instance, as the retirement age approaches, the majority of persons who invest for their retirement maintain fewer holdings in equities and larger holdings in bonds and cash.
If your risk tolerance, your current financial condition, or your financial goals change, you could also need to adjust the way your assets are distributed in your portfolio.
Although the information presented here should not be construed as financial advice, it may serve as a useful jumping off point for a discussion with a financial advisor.
Learn how to locate a financial advisor by reading our comprehensive guide that explains financial advice in detail.