What is asset allocation?
Asset allocation is a strategy aimed at balancing risk and return by diversifying an investment portfolio’s exposure across both asset classes, such as bonds, equities and properties, and the individual securities, sectors and companies within each of these asset classes.
Portfolio managers use their wealth of investment expertise and experience to make these vital decisions, which can be both long-term and strategic in nature or short- to medium-term tactical changes to take advantage of fundamental changes in their value.
How does asset allocation work in practice?
Portfolio managers invest across the different classes to diversify the investment risks.
Asset allocation is based on the proven principle that the different asset classes perform differently in different market conditions. For example, when interest rates fall, equities tend to perform better. On the other hand, money market rates immediately decline and investors receive lower yields.
It is up to the manager to adjust the asset allocation and security selection in a way that will take most advantage of any potential outperformance that could be generated by changing market conditions that are either long- or short-term in nature.
We focus on the long-term, only adjusting our asset allocation when we believe there has been a fundamental change in long-term asset class potential returns or an asset has come to offer at least what we consider to be fair value and preferably attractive upside potential.
Leaving the strategic and asset allocation decisions to an expert makes sense given that the average investors often finds it difficult to know what risk they will actually be able to tolerate ahead of time and often their investment decisions are driven by the emotions they feel during different market conditions rather than their rational, long-term investment goals.
The different asset classes used to achieve the optimum balance between risk and reward are:
equities;
bonds or fixed interest securities (bonds or convertible securities);
cash and cash equivalents (deposit accounts, money market funds);
commercial or residential property;
offshore investments.
Within each of these asset classes there are normally several more sub-divisions.
The challenges of linking asset allocation and performance
Future risk and return predictions are based on history and there’s not guarantee these will be repeated.
As with any investment, there is no guarantee that what happened in the past will be repeated in the future. So, while historically an investment professional knows what asset classes have delivered in the long-run on average, they need to be highly attuned to any changes in market conditions that may be structural in nature and thus impact materially on long-run future returns.
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