Dynamics of asset allocation

Balancing investment risks and returns

Asset allocation plays a crucial role in shaping your financial future. It’s the strategic distribution of your investments across various asset classes, aiding in risk minimisation while bolstering potential returns.

The art of asset allocation is not a one-time affair but a dynamic process that needs revisiting as your financial circumstances and objectives evolve. For instance, nearing retirement may necessitate a shift towards a more conservative asset allocation.

Remember, there’s no one-size-fits-all when it comes to asset allocation. It’s about finding a strategy that aligns with your financial goals and staying consistent over time.
Allocation involves deciding how to distribute your funds among different asset classes (like equities, bonds, property, and cash) and determining the proportion you want to hold in each.

Future needs
Your asset allocation should reflect your future capital or income requirements, the timeframes for these needs, and your risk tolerance. Investment is a balance between risk and return.

Not only does asset allocation help mitigate risk, but it can also optimise your returns without necessarily amplifying portfolio risk. While all investors aim to maximise returns, individual risk appetites vary.

Understanding investment characteristics
‘Asset allocation’ refers to dividing your investments among different assets. Your portfolio can feature diverse assets, each with unique characteristics, including cash, bonds, equities (company shares), and property.

The rationale behind diversifying your investment across different assets is to spread risk and grasp the implications of these characteristics on portfolio performance under varying conditions – embodying the principle of not “putting all your eggs in one basket.”

Navigating through uncertainties
Investments are subject to market fluctuations, and their performance hinges on the asset classes and prevailing market conditions. Such volatility is part and parcel of investing.
Moreover, the potential returns and associated risks of different investments change over time due to economic, political, and regulatory shifts and numerous other factors. Diversification helps navigate this uncertainty by amalgamating various investments.

Your risk tolerance will evolve, influenced by your life stage and responsibilities. Younger investors might withstand a more significant market dip, confident in their ability to recover. In contrast, those in their 40s with commitments like mortgages and families may prioritise safeguarding against such losses.

Exploring asset classes
Building a portfolio involves blending various asset classes or investment types. Cash is the foundation, with the goal of outperforming what could be earned by leaving all investments on deposit.

Cash Investments
Popular cash investments include avings accounts in banks, building societies, and money market funds (investment schemes investing in short-term bonds for institutions and large personal investors).

While cash held in banks is arguably safer than other asset classes, it typically offers the lowest return over the long term. However, maintaining some liquidity is crucial to cover unexpected expenses or income loss without dipping into your core portfolio.

Protecting your money from inflation isn’t guaranteed. Generally, cash savings accounts are not the best long-term option – interest rates are often lower than inflation, resulting in continuous loss of value.

Bond Investments
In simplest terms, bonds are IOUs issued by entities like governments or corporations. As an investor, you provide an initial investment, and in return, the issuer pays a pre-agreed regular return, also known as the ‘coupon’. This occurs over a fixed term, at the end of which your initial investment is returned.

Bond risk can vary widely, depending on the issuer’s financial stability. Riskier issuers often offer more attractive coupons to entice investors.

Bond market dynamics
As long as the issuer remains solvent when the bond matures, you’ll receive the bond’s initial value. However, several factors, including interest rates, inflation expectations, and the issuer’s credit quality, cause the bond’s price fluctuation during its lifetime.

For example, the value of government bonds is particularly affected by changes in interest rates. Similarly, high inflation can reduce the real value of future coupon payments, making bonds less appealing and driving their prices lower.

Equities Investments
Equities, also known as shares in companies, are generally considered riskier than bonds. However, they tend to yield higher returns over an extended period. This is because share prices can significantly increase as the company expands.

Returns from equities are primarily derived from changes in the share price and, occasionally, dividends paid by the company to its investors.

Factors Influencing equity performance
Share prices are constantly fluctuating due to various factors such as company profits, economic background, and investor sentiment. For instance, a company’s future profitability prospects can affect share prices. Similarly, a poor outlook for economic growth could indicate declining demand for the company’s products or services, affecting share prices.

Property Investment
When investing, property usually refers to commercial real estate – offices, warehouses, retail units, etc. Unlike equities or bonds, properties are unique; only one fund can own a specific property.

Dynamics of property investment
Changes in capital values can sometimes dominate property performance. Also, property investment involves considerable valuation and legal involvement, making it less liquid than equities or bonds.

Rental income is usually the main driver of commercial property returns. Property owners can enhance their assets’ income potential and capital value through refurbishment or other improvements. With proper management, the stable nature of the property’s income return makes it an attractive option for investors.

Predicting the future of investments is a game we cannot win. If possible, we would pinpoint the exact date when we need our money back and opt for the investment promising the highest return at that time. This return could come from many assets – company shares, bonds, gold, or any other asset class. The challenge lies in our inability to foresee what lies ahead.

To counteract this unpredictability, diversification comes into play. By amalgamating a variety of investments, diversification provides a safety net. Portfolio managers, aiming to boost the performance potential of a diversified portfolio, continually adjust the mix of assets they own based on current market trends. These adjustments can occur at multiple levels – the overall asset mix, the targeted markets within each asset class, or even the risk profile of underlying funds within these markets.

Adapting to market conditions
In a climate of positive or rebounding economic growth coupled with a high-risk appetite, it’s common for managers to increase their equity weighting while decreasing their exposure to bonds. Within these broad asset categories, managers may also gravitate towards more aggressive portfolios during prosperous market periods and resort to more conservative ones during challenging times. Variables like local economic growth, interest rates, and political landscape significantly influence the balance between equity and bond markets.

Tailoring underlying portfolios
Regarding the underlying portfolios, managers typically adopt a defensive stance in times of low-risk appetite.

For instance, in equity, they lean towards larger companies operating in sectors less dependent on strong economic growth. Conversely, when risk appetite is high, these portfolios tend to increase their exposure to sectors more sensitive to economic fluctuations and smaller companies.