What is Asset Allocation and why is it important

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Asset allocation is an investment portfolio management technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, and property. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much. This is because the various asset classes are not directly correlated to each other, and so will produce differing returns over different time horizons. Various studies have shown that a large percentage of performance comes from the right asset allocation as opposed to individual fund or stock selection.

In determining the right asset allocation strategy for you, consider your:

  • Unique financial situation
  • Comfort with investment risk and flexibility
  • Retirement goals and time frame

In general terms, if you are further from retirement, a portfolio with a higher allocation of stocks or stock funds may be appropriate. More aggressive asset mixes with higher stock allocations may give you greater growth potential. Care should be taken of leaving long-term savings in highly conservative choices where they may not outpace inflation and actually decrease in value in real terms. When planning your asset allocation, careful consideration should be given to balance your need for growth, income, and capital preservation.

As you get closer to retirement, you may want to gradually shift toward more conservative investments, such as bond or money market funds. A conservative mix focuses more on the preservation of your money, but can still include equity funds. With retirement possibly spanning thirty years or so, a balance between growth and preservation will still need to be maintained to ensure that the fund is able to provide you with an income for all of your retirement.

A report by Ibbotson and Kaplan reached the following conclusion. What part of a fund performance is explained by asset allocation? If the answer is thought of as a multiple choice question with 40%, 90%, 100% and all of these as the choices, their analysis showed that asset allocation explains about 90% of all the variability of a fund’s returns over time, but only explains about 40% of the variation of returns among different funds. Furthermore, on average across funds, asset allocation policy explains 100% of the level of returns. Because the question of fund performance can be interpreted in any or all of these ways, the can be viewed as all of the above.

In summary, asset allocation is a key tool to help manage and maintain an investment portfolio to make sure it meets the required goals, while only exposing your portfolio to an agreed level of risk.

Seek your financial advisor’s help with asset allocation to help put a plan in place that meets your financial requirements, or contact [email protected] to have any questions you may have answered.

(Written by James Thomas| ACUMA – Independent Financial Advice)

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