Asset allocation, or the proportions of a portfolio that are invested in the various asset classes, is key to long-term performance.
Asset allocations will be determined by your personal investment goals and your risk tolerance. If you want to build a bigger investment pot over a particular period then you must be prepared to take more risks. Although your portfolio suffering losses, or drawdowns, can be stressful, patience can be rewarding. You can assess your risk tolerance here.
In general:
- Equities will deliver higher returns over time but they are also more volatile than other asset classes
- Bonds are generally less risky than equities but the returns can be lower
- Cash is the most secure of assets but low interest rates mean returns probably won’t even beat inflation
- Real estate can deliver inflation-linked income from rents and some capital growth
- Commodities can deliver inflation-linked capital growth but returns can be cyclical and volatile
Diversification can optimise steady growth
Portfolios will have varied exposures to each of the asset classes listed above but a diversified allocation across them all can reduce the level of volatility associated with each individual asset class. This is because different asset classes often perform differently at different times, delivering positive returns when others are delivering drawdowns and thus spreading your risk.
Ready-made strategic asset allocations for different time spans and risk tolerances, based on research into the long-term performance, volatility and correlations of a range of asset classes, are offered to investors. For more information on diversification see here.
Time is the investor’s friend
The length of time that the portfolio will be invested for is also important. A 21-year-old graduate starting a career and who wants to build up life savings over 30 years can take more risks with their portfolio than a 55-year-old who wants a nest egg for their retirement in five years’ time. The 21-year-old might wish to allocate 75% to equities and 25% to bonds, for example, whereas the 55-year-old might prefer a less aggressive portfolio with 25% in equities and 75% in bonds.
It is also worth bearing in mind that within the asset classes, certain investments offer higher returns and present more risks than others. For example, equities in Emerging Markets are more likely to be higher risk than those in developed markets such as the US or Europe. It is important, therefore, to diversify within asset classes as well.
Using funds to construct the portfolio
Once you have determined your preferred asset allocation, or ‘weightings’, including to the underlying sectors, you need to select the investment vehicles into which you will deploy your capital. To aid diversification and because they do not want to choose which individual companies are bought and sold, many investors choose to use ‘mutual’ funds such as unit trusts, open-ended investment companies (OEICs) and exchange traded funds.
Reviewing your portfolio
Portfolios should be reviewed at regular intervals, and at least annually, to ensure their performance is reasonable versus your expectations. If some assets outperform strongly and others underperform then weightings can be rebalanced to ensure they remain in line with the required overall asset allocation strategy. It may also be that market events have caused you to re-evaluate your risk tolerance and you may wish to adjust your overall allocation strategy.
Liontrust offers a range of multi-asset funds in which we actively manage the asset allocations and underlying assets based on various risk levels.
You may wish to seek the advice of a professional financial adviser.
