Optimising Returns and Minimising Risks: The Importance of Asset Allocation in an Investor’s Journey

Optimising Returns and Minimising Risks: The Importance of Asset Allocation in an Investor’s Journey

1 Jun, 2023 | Investment Philosophy, Stock Insight

Successful investing goes beyond making smart decisions; it requires avoiding mistakes and adopting a mindset of longevity and endurance. While taking risks and investing optimistically are important for building wealth, keeping your wealth also demands a mix of humility, frugality, and steering clear of catastrophe.
Investment asset allocation and rebalance

All investment journeys evolve in different ways, with many twists and turns along the road. Everyone has different goals which have varying return requirements in a landscape of changing risk profiles. As investors, if we invest in just one asset class today and then go to sleep on it for years, we could wake up to a rude shock. Not only do investment goals evolve as time goes by and experience accumulates, the assets that we invest in also have varying risk/return profiles over time.

Finance and investment writers tend to lend attention to things that are huge, profitable, famous, or influential. Of course, celebrating wins and helping investors find tails that wag the dog i.e. security selection is important. However, it is equally (if not more) important to emphasise one crucial aspect that is often less spoken about in achieving long-term financial success: asset allocation.

What is Asset Allocation?

Asset allocation is the process of determining where to invest money in the market. It involves apportioning a portfolio’s assets across different asset classes, such as equities, real estate, bonds, cash, and other options like private equity and alternative investments. The key principle behind asset allocation is that different asset classes do not move in perfect correlation with one another, meaning their performance doesn’t rise or fall at the same magnitude simultaneously.

Why is Asset Allocation Important?

Asset allocation has a significant impact on the overall returns of a portfolio. Choosing the right asset allocation maximises returns relative to an investors risk tolerance. This means it helps an investor get the highest payoff possible for the amount of money willing to be risked in the market.

Diversification is a key component of asset allocation. It applies not only to the split between asset classes but also within asset classes. By diversifying across different regions, sectors, and investment styles within equities, and across various segments and durations within bonds, investors can reduce risk and potentially achieve a less volatile overall portfolio return. Diversification protects wealth by spreading investments wisely, mitigating the impact of a decline in any single investment or asset.

Types of Assets to Consider: Avoid Putting All Your Eggs in One Basket

The famous saying “don’t put all your eggs in one basket” is especially relevant in asset allocation. By diversifying investments across various asset classes and within each class, investors can reduce exposure to any single investment’s risks. This strategy helps mitigate losses if one asset performs poorly while others compensate.

When allocating assets, investors have a wide range of options to choose from. These may include:

Equities: Investing in stocks represents ownership in publicly traded companies and offers the potential for long-term capital appreciation. Equities can be diversified across different industries, sectors, and geographical regions.

Fixed-Income Investments: Bonds and other fixed-income instruments provide a steady income stream and are considered less risky than equities. They can include government bonds, corporate bonds, municipal bonds, and treasury bills.

Cash and Cash Equivalents: These include money market funds, term deposits (CDs), and savings accounts. Cash investments provide stability and liquidity, making them suitable for short-term needs and emergencies.

Real Estate: Investing in real estate can provide both income and potential appreciation. This can be achieved through direct property ownership or real estate investment trusts (REITs).

Alternative Investments: Hedge funds, private equity, commodities, and other alternative investments offer diversification and potential returns not correlated with traditional asset classes. However, they often involve higher risks and may require specialised knowledge.

Portfolio Rebalancing and Asset Allocation

Asset allocation isn’t a one-time event. Your desired asset allocation changes over time as you get closer to your goals. But even before then, you may notice portfolio drift, or the movement of your allocations away from where you set them. This could happen if stock values rise suddenly or if bond interest rates (and their associated prices) fall.

Most experts recommend you check in on your portfolio once or twice a year to see how it’s doing. Depending on your holdings’ performances, you may need to rebalance, or sell some securities and buy others to bring your asset allocation back into line.

Risk-Reward Ratio and Individual Goals

By clearly defining target returns and assessing risk tolerance, investors can align their asset allocation with their individual goals. Remember, striking the balance between risk and reward is an individual pursuit – time horizon, risk tolerance, personal preferences and goals vary from person to person. For example, here are retirement scenarios for three different investors:

Investor A, a 22-year-old with a retirement goal in 40 years, possesses a high tolerance for risk. Their main objective is to increase their retirement savings over the next four decades. They acknowledge the market’s fluctuations but prioritise investments that offer the potential for higher returns. Their ideal portfolio would be diversified and expose them to the stock market, known for its historically high rates of return. Here’s an example of asset allocation:

  • 80% allocation to equities
    • Within equities:
      • 30% in mid-cap & large-cap stocks
      • 70% in small-cap stocks
  • 15% allocation to real estate
  • 5% in cash

Investor B is 40 years old and plans to retire in 15 years, indicating a moderate risk tolerance. Although they have more than a decade left until retirement, the limited time frame hinders their ability to recover from significant market losses. They are open to taking some risk to continue growing their money, but they cannot afford to lose substantial amounts before retirement. They seek a diversified portfolio that offers moderate upside potential while safeguarding them against major market downturns. Here’s an example of their asset allocation:

  • 40% allocation to equities
    • Within equities:
      • 50% in mid-cap & large-cap stocks
      • 50% in small-cap stocks
  • 40% allocation to real estate
  • 10% in bonds
  • 10% in cash

Investor C is 65 years old and has just commenced retirement, possessing a low tolerance for risk. Their primary goal is to preserve their capital while still seeking selected opportunities for growth, without taking on excessive risk. As they plan for their retirement savings to last for at least the next two decades, avoiding losses becomes crucial. Their preferred retirement portfolio would be diversified and structured as follows:

  • 30% allocation to equities
    • Majority of holdings are income producing large-caps with long operating history
    • Smaller allocations to growth opportunities
  • 30% allocation to bonds
  • 20% allocation to real estate
  • 20% allocation to cash

While the above are just examples, they do illustrate how investors allocate assets in their portfolios based on their risk tolerance and time horizons. It is important to note that these profiles serve as samples and demonstrate how asset allocations may vary according to different risk tolerances and time horizons.

The TAMIM Takeaway:

Understanding the importance of asset allocation is crucial for investors. By diversifying portfolios across different asset classes and within each asset class, investors can optimise risk-adjusted returns. While not as “fun” to talk about as individual stock selection, asset allocation plays a dominant role in determining the overall return of a portfolio.

Diversification is acritical element in protecting and sustaining wealth by ensuring that investments are spread wisely across various baskets. Building a well-diversified portfolio aligned with individual goals and time horizon is key to long-term success in investing.

Sign Up to Our Weekly Stock Insights

* Indicates required field



Popular Topics