Definition of asset allocation

Asset allocation is the process of spreading, or 'diversifying', your investments across a range of different asset classes and geographical regions - to minimise the risk of all your investments falling in value at the same time, and to maximise the potential for smoother, and therefore higher, compound returns.

By diversifying your investments across cash, shares, bonds, property, commodities, private equity and alternative investments, you reduce the impact of price volatility in any one of these assets classes on the overall value of the portfolio.

In simple terms, it is the investment equivalent of not ‘putting all your eggs in one basket’.

Asset allocation is most effective in minimising risk when the assets chosen rise and fall in value independently of each other – ie their price movements are not correlated.

The choice of asset classes in a portfolio is also the single most important determinant of investment returns, according to research by Brinson, Hood and Beebower.

Asset allocation can effectively diversify the portfolio of a UK share investor through the addition of shares or funds from other sectors or geographic regions, or through the addition of shares that are less correlated with UK shares, for example government bonds, commodities and gold. However, it is becoming increasingly difficult to find uncorrelated assets.

Managers tend to refer to different types of asset allocation. An investor might be recommended to start with a strategic asset allocation which gives the potential for the returns needed at a level of volatility he or she can tolerate. Tactical or dynamic adjustments can then be made. A simple strategic allocation for a 25-year investment term might be 50 per cent equities, 25 per cent bonds, 15 per cent property and 10 per cent commodities. 

Tactical asset allocations involve a short-term deviation from the strategic asset allocation, for example by increasing the exposure to commodities when they are in demand and then reverting to the strategic level after realising short-term profits

Constant weighting asset allocation involves responding to a rise or fall in portfolio values, for example, if equities rose in value to 60 per cent from the strategic 50 per cent level, shares would be sold and other assets bought to restore the weighting.

Dynamic asset allocation involves the regular adjustment of the mix of assets in a portfolio to take advantage of changing market conditions. For example if shares were rising, more might be bought in anticipation of continued gains.[1]

 

Learn more at the FT Money Gym

 

asset allocation in the news

In January 2014, an FT writer considered the wisdom of investing in a stock-picking or an asset allocation strategy. The former would involve identifying particular companies that were going to do well, while the latter would have involved a broader decision to invest in a particular market or sector. He said that in 2013 a hard working and lucky investor might have been able to get good results following a stock picking strategy in UK markets, but would have performed equally well following a far simpler passive approach to US stocks where a tracker on the S&P 500 would have returned 31.5 per cent over the year.