Asset allocation is the process of systematically dividing an investor’s assets across different geographies and asset classes with an objective to balance risk and returns. Asset allocation is implemented by combining different asset classes. An asset class is a group of assets that demonstrate similar attributes and risk-return relationships. For example, stocks, bonds, real estate, and gold are considered separate asset classes.
How does asset allocation function in controlling risk?
Each asset class has unique risk-return relationship. At different stages of an economic cycle, different asset classes perform differently. Factors that might cause an asset class to perform well might cause another to deliver adverse performance. For example, during natural calamities or wars, stocks perform poorly while gold has historically demonstrated higher returns as it is considered a safe-heaven. The concept of asset allocation is based on this principle of how assets perform relative to each other in different economic conditions, so that each asset class can offset certain risks and enhance long-term returns. Investors invest in different asset classes with expectations that if one is losing money, then another would make up for those losses.
The process of determining suitable asset allocation is complex as it aims to adapt to personal situations and goals of an investor. The process seeks to effectively balance an investor’s return and risk objectives. Time horizon is an important determinant. For example, a young professional with stable job and no dependent would have more time to recover from adverse investment outcome (loss) than a retired person with fixed payments such as healthcare expenses. The asset allocation of the former would be more aligned towards risky assets compared to the more conservative asset mix for the retired investor. Another important determinant is risk tolerance of an investor. A wealthy investor with an adventurous mindset is expected to have more risk appetite and would have riskier assets in asset allocation compared to a cautious investor with stable earnings, whose asset allocation would consist of asset classes that preserve savings and provide steady growth prospects.
Different investors are expected to have different investment objectives and abilities to take risks. Therefore, an asset allocation suitable for one investor may not be suitable for another.
The importance of asset allocation
Asset allocation decision is among the most important decisions that investors make. Studies indicate that what makes the real difference to a portfolio’s risks and returns is not which shares or bonds were chosen to invest but what percentage of the total portfolio was invested in each asset class. A study conducted by Brinson, Hood, and Beebower (1986) concluded that asset allocation explained an average 93.6% variation of returns over time for 91 large US based defined benefit pension plans.
Studies indicate that investors often stick to the asset class they are most familiar with and ignore the others. This exposes their investments to the same risk factors as often all assets within the same asset class move together. It not only increases risks, but also limits the opportunities to benefit from favorable movement in other asset classes. By spreading investments across different asset classes, asset allocation prevents investors to put all eggs in one basket. This is called diversification of assets. It reduces risk and enhances long term returns.
Asset allocation enables investors to stay disciplined in making investments and improves consistency of returns. It increases certainty that adequate funds would be available to meet important requirements such as mortgage and insurance payments.
The process of asset allocation is ongoing and the weights of different asset classes are periodically assessed to adapt to changing personal situations and conditions in financial markets. It increases investors’ resilience to unforeseen personal conditions such as job loss or disability. A portfolio that consists of well diversified asset classes exhibits greater ability to withstand losses during extreme conditions in financial markets such as crash, economic crisis or prolonged depression.
In short, asset allocation develops a reliable systematic framework under which individuals can invest their savings to achieve their long term financial goals.