What is asset allocation?

Key takeaways

  • When you divide an investment between asset classes it is called asset allocation.

  • Asset allocation gives you the benefits of diversification – when one asset class performs poorly this may be offset by good returns in another asset class.

  • Asset allocation decisions are more important than the decisions concerning which shares, bonds or any other securities you should invest in.

  • Your asset allocation decisions should be determined by the returns you require, your investment term and your tolerance for risk.
  • Some managers use a strategic or static allocation to asset classes. Others are more active and change the allocation depending on the outlook for the asset classes.

What is asset allocation?

Asset allocation refers to the way money you invest is allocated or divided up between different asset classes – primarily shares, bonds, listed property, cash and alternatives. The aim of allocating to different asset classes is to give you the best return with the least amount of risk.

By investing across asset classes you enjoy the benefits of diversification because the different asset classes deliver returns at different times. If one asset class performs poorly, those returns may be offset by higher returns from another asset class. Read more: Why should I diversify my investments?

If you invest in shares only, you may achieve the highest returns over the long term, but you are likely to experience a big range of returns over that period, including some periods where your investment will show losses. Read more: How to make money investing in shares.

Putting some money in bonds or cash, for example, can reduce the range of returns you experience over short terms without impacting the long-term average return.  

Why is asset allocation important?

Asset allocation is regarded as one of the most important things that determines your final returns.

Asset allocation, rather than the choice of shares, bonds or any other investments, has been identified as the investment decision that determines 90% of the variability of the returns you earn.

Picking winning shares or bonds or other securities or the timing of your entry into the market, plays a much lesser role in determining the returns you earn.

This was confirmed by research by William Sharpe, the Nobel Prize winner for Economics and US-based research house Ibbotson and Associates.

What should influence my asset allocation?

Three things should influence your asset allocation decision:

  • The return you need;
  • Your investment time horizon; and
  • Your capacity for and ability to take investment risk.

A financial adviser should help you identify the investment return you need in order to meet your financial goal – saving for your children’s education, for a holiday or for retirement. For example, if you are saving for retirement, you may need to earn a return that matches inflation and gives you an additional 5% growth a year.

To achieve this return you will need a fairly high exposure to shares or equities and an investment term of at least five to seven years. The asset allocation of such a portfolio is often referred to as more aggressive.   

However, if your investment time horizon is shorter, for example, only three years, you may need a lower exposure to equities and more cash and bonds in your portfolio, to reduce the chances of a negative return over that period. The asset allocation of such a portfolio is often referred to as more conservative.  Read more: What do I need to know about investment risk? 

Advisers, or discretionary investment fund managers advisers use, will then determine the asset allocation you need to achieve that return within the period for which you will be invested. Read more: What do I need to know about investment risk and time?

You then also need to check that you are able to tolerate the risks. Read more: What is my risk profile and why does it matter?

If you are not using an adviser, you can choose the appropriate unit trust multi-asset funds or exchange traded fund where the fund manager determines the asset allocation. The fund’s fact sheet should give you an indication of the returns you can expect from the fund. Read more: Why are there different kinds of multi-asset funds?

Retirement savings invest across asset classes

Any retirement fund savings you make must be invested across asset classes in line with the prudential investment guidelines in regulation 28 of the Pension Funds Act. If your fund provides the investment options, these will include asset allocation in line with regulation28.

If your fund offers investment choice through an investment platform, you can choose multi-asset funds that are regulation 28 compliant or you will be guided on when your investment fund choices result in your asset allocation exceeding regulation 28 limits, but beyond that the allocation will be up to you or your financial adviser. Read more: How are my retirement savings invested?

Who should make asset allocation decisions?

Picking the appropriate asset classes and blending the classes to ensure the best returns for the level of risk you are able and prepared to take is a skill that most regard as best suited to investment professionals.  

Many investors make use of multi-asset or asset allocation funds, where professional fund managers with experience in managing multi-asset portfolios select and combine asset classes.

Your financial adviser may determine the appropriate asset class for you or outsource the asset allocation and portfolio construction to a discretionary fund manager who will choose managers from different financial institutions and with different investment styles.

Asset allocation strategies

Investment managers use different asset allocation strategies.

Strategic asset allocation: The manager determines what it believes is the optimal asset allocation to the different asset classes for the long term and sticks to that set allocation at all times. Market movements will cause the portfolio to deviate from that allocation but the manager will at regular intervals adjust it or rebalance it back to the strategic allocation. The optimal allocation will only be reviewed every few years.

Tactical asset allocation: The manager has a strategic asset allocation but will make tactical decisions to deviate from that allocation to take advantage of market conditions. This is a more actively managed asset allocation strategy that can enhance returns but also introduces the risk of the manager making the wrong tactical calls on when to increase or decrease exposure to a particular asset class.

Bottom-up allocation: The manager chooses securities from different asset classes based on their relative valuations or prices relative to earnings. The exposure to asset classes then depends on where the manager finds the best investment opportunities.   

Target-dated allocation: The manager changes the asset allocation by reducing the exposure to riskier asset classes like equities and increasing the exposure to more conservative asset classes as you approach retirement.