Beginner’s Guide to Asset Allocation

Asset allocation is one of the first — and one of the most important — things that people need to consider when creating an investment portfolio.

This guide will explain what asset allocation is, the different types of asset class an investor can choose from, and how an individual can select assets based on their risk profile.

What is asset allocation?

Asset allocation is the process by which a person chooses what asset class to invest in. There are three factors that determine how they ultimately decide to allocate their money:

1. Time
2. Risk
3. Investment goals

Ways to allocate your money

There is a wide spectrum of assets that investors can choose to invest their money in. However, there are three main categories that dominate the conversation when we talk about asset classes: cash (or cash equivalents), bonds, and shares.

Each of these classifications exposes an asset owner to different levels of risk. Cash is by far the safest way place for someone to invest their money, followed by bonds, and then stocks.

However, on the flip side, cash offers lower returns than those other two asset classes. Essentially, the higher return a person makes from stocks, for example, is their reward for accepting the risk they might not get some (or all) of their money back.

It’s important to differentiate between the investing terms ‘asset allocation’ and ‘diversification.’ The former concentrates on the proportion of one’s wealth held in different asset classes. The latter refers to the spread of securities that an investor buys within each of these asset classes.

Why is asset allocation important?

The difference in returns across these three asset classes can be colossal. So it’s important for an investor to carefully consider what percentage of their money they invest in each one. 

In fact, asset allocation is more critical than deciding which individual securities to buy (like whether I decide to buy Lloyds or Amazon stock). Let’s look at an example.

Let’s say that you decide to park your money in Aldermore Bank’s low-risk Easy Access savings account. The interest rate here between September 2012 and September 2022 ranged between 2.85% at the beginning of the period and 0.5% between August 2020 and March 2022.

Even at the highest rate, this account would provide a much-lower annual return than you could have made with higher-risk UK shares. Over the last 10 years, for instance, the FTSE 100 has delivered an average yearly return of 7.38%, according to trading firm IG Group.

Now let’s see what difference these diverging returns could make to an asset owner’s bank balance after a decade. A decade ago, £10,000 invested in a FTSE 100 tracker fund would have more than doubled to around £20,380 today. That’s assuming reinvestment of all dividends.

Aldermore’s Easy Access savings account would have yielded much less. In fact, let’s go crazy and say that the account offered its best rate of 2.85% throughout the entire period. That investor would still have made a far-less-impressive £13,255.

An individual might be happy to sacrifice a lower investment return for reduced risk. But a cash account is unlikely to be suitable for someone whose investment goal involves achieving higher-than-average returns. They would be better with an asset allocation strategy that prioritises investment in stocks, for example.

The four rules of asset allocation

There is no correct answer as to how someone should go about allocating their assets. Every one of us has different investment goals, attitudes to risk, and different time periods for which we are happy to invest our capital. 

However, the following rules can help an investor decide how to allocate their money.

Rule 1: If you need the money in the next 12 months, choose cash

Stock and bond market crashes can happen in the blink of an eye. Even the most experienced investor can’t guarantee when the next correction will happen. So you don’t want to invest in these risker asset classes if you need the money within a year.

History shows that stock markets always rebound from crashes. But this doesn’t help those who need to draw out their capital after a short period. Market recoveries are often slow and lumpy and asset values can take years to get back to pre-crash levels.

This is why investing in a cash account is a better option. If you park £10,000 in one today, you know you’ll be able to draw that exact sum out a month from now. Even if the bank goes bust the Financial Services Compensation Scheme means you’ll be able to reclaim your capital (up to a maximum of £85,000).

Rule 2: If you need the money in one to five years, choose low-risk investments

Investors who need to access their money after a short-to-medium period of time might also want to purchase more defensive assets. 

So, for example, someone looking to access their capital within five years might want prioritise government or corporate bonds. They might also want to take a look at fixed-rate cash accounts that lock their money up for 12 months or longer. These products tend to offer better interest rates than instant-access cash accounts.

Low-risk investments like these are also a good idea for someone who cannot afford to lose some or all of their money. These include funds put away for retirement or to pay for a child’s path through university.

Rule 3: For any money you don’t need for at least five to seven years, choose shares

We at The Motley Fool are big fans of investing in the stock market. This involves higher risk than most other assets but, over a prolonged period, share investing is a proven way to create wealth.

For example, IG Group has calculated the average annual return of the FTSE 100 during the past 10 years at 7.38%. It puts the average yearly return since the Footsie’s inception in 1984 to 2019 at an even-better 7.8%, too.

In the short term, it’s impossible to predict how stock markets will behave. And this leaves massive uncertainty over what returns one can expect to make. An asset owner who bought shares at the start of 2020, for example, would have been burnt by the end of the year as Covid-19 battered the global economy.

But taking a longer-term view can be an effective strategy to generating cash. This gives the market time to recover from any periods of temporary volatility and consequently deliver solid returns.

Rule 4: Always own shares

For investors who have time to wait, stock investing is — in our opinion — the best way for them to make their money work for them. It’s also an effective way to neutralise the impact of runaway inflation. And the evidence is there to prove it.

According to a Barclays Capital Equity-Gilt Study, shares have beat bonds in 80% of all 10-year rolling periods over the last 100 years. The performance of shares against cash is even more impressive, with shares producing a greater return in over 90% of 10-year rolling periods.

Again, there is no right and wrong answer when it comes to asset allocation. But one good way to calculate how much of your long-term savings you should use to buy shares can be to study ‘The Rule of 110.’

Basically, this involves subtracting your age from 110 to get the percentage of how much to invest in shares. So if you’re 30 years of age, you’d look to put 80% of your money into stocks. If you’re aged 50 years you’d invest 60% in equities. And so forth.

What is an asset allocation fund?

An asset allocation fund can be a useful shortcut to help investors diversify their wealth. 

These investment vehicles tend to concentrate on those three asset classes of cash, bonds, and equities. And they have different weightings across these categories based on an individual’s tolerance of investment risk and their targeted returns.

For example, an asset allocation fund could offer a weighting of 60% stocks and 40% bonds. This particular fund could be attractive to that 50-year-old described above. 

These funds mean that an investor can easily diversify their portfolio without having to search for individual securities to buy. But be aware that these can carry a swathe of fees and charges that can take a big bite out of one’s eventual returns.

Creating a diversified portfolio across different asset classes is essential for the modern investor. A sound asset allocation strategy that incorporates both defensive assets and higher-risk investments can be the difference between one exceeding their investment objective and enduring a disappointing portfolio performance.