What is Asset Allocation? Why and How Does It Work?

What is Asset Allocation? How does it work? Why does it work? All interesting questions with plenty to think about when answering them. Let’s get on with it.

What is Asset Allocation

Firstly, what exactly is Asset Allocation?

Asset allocation essentially refers to the process of investing your money into different types of investments, such as stocks, bonds, real estate, or commodities.

The goal of asset allocation is to create a diversified portfolio that will provide you with a steady income over time while also reducing risk.

This means that if one investment goes down in value, another may go and counter the loss incurred in the other one.

By spreading out your wealth among various assets, you can reduce the overall volatility of your portfolio.

Related: Why Are Equities Volatile?

How Does Asset Allocation Work?

The basic idea behind asset allocation is simple: spread your money around so that when one investment decreases in value, most others either don’t decrease or (preferably) rise in value.

This is ultimately because of the effects of diversification. When you have a diversified portfolio, most of the firm specific risk of investments is eliminated.

What you’re left with, largely, is the non-diversifiable market risk that every single investment is exposed to.

Why Is Asset Allocation Important?

In addition to the risk-reduction effects we highlighted above, asset allocation is actually also important for the other side of the coin – investment return.

Investing in just one stock, or even just a single “asset class” (e.g., only stocks) can result in suboptimal results.

For example, investing exclusively in bonds could mean that you may not earn enough of a return to cover inflation.

This would make you very susceptible to the effects of the time value of money.

By pooling together a variety of asset classes that complement one another, you can play to each one’s individual strengths and overcome their individual weaknesses.

Furthermore, holding a diversified investment portfolio brings peace of mind in that you don’t need to anxiously contemplate whether you “picked the right stock” or if you paid too much for a security.

As long as you consistently invest a similar or gradually increasing amount of money across multiple asset classes, you’ll almost certainly end up thriving and being resilient during times of crisis.

Okay, now that you know what is asset allocation, how it works, and why asset allocation is important, let’s think about the key asset classes.

What Are The Key Asset Classes?

The key asset classes include:

• equities (aka stocks)
• fixed income investments (such as bonds, cash equivalents like Treasury bills and certificates of deposit)
• commodities (e.g., gold, silver, oil, etc)
• real estate (commercial and residential property)
• alternative assets (including digital assets, startups, private equity, venture capital, etc)

This isn’t quite an exhaustive asset category list, but it’s a pretty comprehensive and representative one.

Now, how do you ensure you get exposed to a variety of asset classes? What are the types of strategies for asset allocation?

Well, you could either buy individual securities across different asset classes on your own, or you could buy a fund which holds a variety of asset classes.

Let’s consider both.

What are the Types of Asset Allocation Strategies?

As we said earlier, you could either:

• conduct asset allocation yourself (by buying a variety of securities across different asset classes), and/or
• buy a fund that’s already diversified and holds a variety of asset classes

DIY Asset Allocation

The first option – DIY if you will – can be incredibly time consuming, and expensive.

Buying individual securities will also often mean high transaction costs (e.g., brokerage fees, high bid-ask spreads on certain assets, etc).

The same can hold true at times of rebalancing, when you’ll need to sell some positions or buy more of other positions to maintain optimal portfolio weights.

But, you could argue that doing it yourself gives you greater control in that you know exactly what you’re buying, holding, and selling.

And if you know what you’re doing, this can also mean better control of your investment risk.

Fund Asset Allocation

Alternatively, you could buy a fund that’s done the hard work for you.

In this approach, there are broadly two main types of asset allocation strategies: passive management and active management.

Passive managers typically just follow a market index, whereas active managers seek out opportunities within specific sectors or industries, for example.

In general, passive managers tend to outperform active managers due to lower costs and greater transparency. However, active managers may often provide higher returns (in some years but not consistently) at the expense of increased volatility.

Passively Managed Funds

Index Funds – Index funds typically purchase shares of all publicly traded companies on a market. The idea behind these funds is simple. By buying into the entire market, you eliminate the potential impact of individual stocks’ performance. And since the vast majority of funds cannot beat the market, you may as well “join” the market by replicating it as much as possible.

Target Date Funds – Target date funds typically work towards changing the asset allocation of your portfolio as you age and get closer to retirement. As you age, your investment goals should move away from capital growth (higher risk and higher expected return) to capital preservation (lower risk and lower expected return). These funds will usually allocate a higher weight to bonds and lower weight to stocks as the date gets closer to your intended retirement date.

Balanced Funds – Balanced funds combine several asset classes together to create a well-diversified portfolio. They can help reduce risk by spreading it across different asset classes. Balancing also helps ensure that no single class dominates the rest of the portfolio. That being said, it’s fairly common for balanced funds to have a higher exposure to equities (stocks) vis-a-vis other asset classes.

Actively Managed Funds

Mutual Funds – Mutual funds are typically managed by a “mutual fund manager” whose role will usually involve identifying which securities to invest in and what proportion to invest in those, with the objective of earning a return that is greater than the market return, for a comparatively lower or equal risk. In reality, over the long-term, most mutual funds will tend to underperform the market portfolio.

Funds of Hedge Funds – A fund of hedge funds invests directly in managed accounts of hedge funds. Investors pay fees for this service which allows them access to specialized expertise from experienced investors who manage money for others.

This isn’t an exhaustive list by any means, but the fundamental idea is this…

Actively managed funds are actively managed by a fund manager of some sort. They’ll typically implement some form of strategic asset allocation or tactical asset allocation.

Passively managed funds are not actively managed by a fund manager. Their investment strategy usually just focuses on replicating the market portfolio (e.g., the S&P500 stock market index).

How Can I Get Started with Asset Allocation?

If you want to start investing today, here are three steps you can follow to begin building a diversified investment portfolio:

1) Determine Your Investment Goals & Risk Tolerance

Before you decide where to allocate your capital, first determine your investment goal and risk tolerance.

What does “risk” mean to you? There are over 188+ definitions of risk as highlighted in this academic study.

What are your investment goals and investment objectives? In other words, why do you want to invest?

Are you looking to:

• retire early?
• build a large safety net?
• simply enjoy spending time with family and friends?

Once you understand your needs, you’ll be better equipped to choose an appropriate mix of stocks, bonds, real estate investments, precious metals, and other assets.

Put differently, you’ll be in a stronger position to create an implement an appropriate investment strategy.

2) Set Up An Investment Plan

Now that you know what type of investor you are and what your risk preferences are, you’ll need to set up an investment plan.

This means deciding exactly how much money you want to commit to investing over the next few decades.

You can determine the amount by figuring out how much income you expect to receive every month after paying for the “non-negotiables” (rent/mortgage, bills, food, clothing, etc)

Remember, consistency is key when it comes to investments.

3) Choose The Right Investments For You

Once you’ve determined your financial situation, you’ll then need to select which types of investments best suit your needs.

There are many different options available, including:

• mutual funds
• exchange-traded funds
• individual equities
• fixed income securities
• REITs
• commodities
• cryptocurrencies like Bitcoin (treat as not dissimilar to gambling)

Choosing a Strategy

Each option has pros and cons, but ultimately they’re designed to help you achieve specific objectives. So before choosing any particular strategy, ask yourself these questions:

• Do I prefer stability or growth?
• Am I willing to accept higher volatility?
• Will my savings last longer in the long run?
• Is this something I’m interested in doing on a regular basis?

The answer to these questions will help guide you toward the most suitable approach.

And remember, there’s no single solution that works for everyone.

But it’s fair to say that starting small and keeping things simple by using index funds will hold you in good stead.

Index funds allow you to invest in a broad range of market sectors while still offering low fees.

4) Monitor Your Progress

As you begin investing, make sure you keep track of your progress. It can be helpful to use online tools like Personal Capital, Mint, or YNAB.

These apps provide easy access to your spending habits, allowing you to see where you stand financially and identify areas where you can cut back.

They also give you insight into whether your current portfolio allocation makes sense based on your goals.

5) Keep Track Of Costs & Taxes

When it comes to taxes, you should always consult a professional advisor first. However, here are two things you can do to minimize costs and maximize returns:

a) Use an Online Brokerage Account

If you want to avoid paying brokerage commissions, consider opening an online brokerage account instead. This allows you to trade stocks directly from your computer without having to pay exhorbitant commission charges.

b) Consider Using A Fee-Only Advisor

A fee-only advisor doesn’t receive compensation from investment companies, meaning she or he isn’t incentivised to steer clients towards certain products over others. Instead, advisors often focus solely on helping investors meet their financial goals through sound advice and research.

6) Set Your Financial Goal For The Future

Once you have a solid plan in place, set realistic expectations about how much money you hope to earn each year. Then, take steps to ensure those earnings continue to grow throughout retirement. Here are three ways to accomplish this goal:

a) Start Saving Early

The earlier you start saving, the more time you have to build wealth before reaching retirement age. If you don’t already have any savings stashed away, now would be a good time to open a tax-free savings account (e.g., Roth IRA in the US, or an ISA in the UK).

b) Invest Regularly

You never know what tomorrow holds, so it pays to stay flexible. As we’ve said earlier, consistency really is key for investing successfully. Not only does this help you achieve long-term growth, but it helps you stay resilient during times of crisis (and there will be times of crisis).

Wrapping Up

Okay, hopefully, you now know what is Asset Allocation, how it works, why it’s important, and what you can do to implement it yourself.

If you’re looking to actively manage your investments, then we’d strongly recommend checking out our Data Driven Investing course which will help you build a scientific system for investing (without fluff). This in turn will help you make robust investment decisions that are backed by the data, math, and statistics.