What Is Asset Allocation?

Open an investment statement and you may see that your money is spread across shares, bonds, cash and perhaps other types of investments.

You might have 60% in shares, 30% in bonds and 10% in cash.

Someone else might have 80% in shares and much less in bonds or cash.

These percentages describe your asset allocation: how your money is divided between different types of investments.

The definition is fairly simple.

The more interesting question is why the proportions matter.

Why might one person have 80% of their money in shares while another has 40%?

And what difference could that make?

To understand that, it helps to look first at the different building blocks of an investment portfolio.

The Main Building Blocks of an Investment Portfolio

Different types of investments are often grouped into categories known as asset classes.

There are several different asset classes, but three of the main ones are shares, bonds and cash.

You might own these investments directly, but often they will be held through one or more investment funds. So even if your statement lists several funds, underneath them your money may ultimately be spread across shares, bonds, cash and other assets.

I explain how this works in What Is an Investment Fund?

Shares, which you may also hear described as equities, represent ownership in companies. They offer the opportunity for growth and may also provide an income through dividends, but their value can rise and fall considerably and future returns are uncertain. You may get back less than the original investment.

You can read more about this in What Is a Share?

Bonds work differently. When you invest in a bond, you are effectively lending money to a government or company. Bonds can provide an income, although their value can also rise and fall as things such as interest rates, inflation and concerns about the borrower's ability to repay change.

I cover bonds in more detail in What Is a Government Bond? and What Is a Corporate Bond?

Then there is cash.

Cash does not normally fluctuate in value in the same way as shares and bonds. If you have £10,000 in cash, you don't suddenly have £8,000 because investment markets have fallen.

That doesn't mean cash is free from risk.

If prices rise faster than the interest your cash earns, its purchasing power will fall over time.

Shares, bonds and cash behave differently.

That is why the proportions held in each can matter.

Why Does the Mix Matter?

Imagine three people each have £100,000.

The first has £80,000 in shares, £15,000 in bonds and £5,000 in cash.

The second has £50,000 in shares, £40,000 in bonds and £10,000 in cash.

The third has £20,000 in shares, £50,000 in bonds and £30,000 in cash.

They all have £100,000.

They all own shares, bonds and cash.

Yet their investments could behave very differently.

The first portfolio has much greater exposure to what happens in stock markets. If share prices rise strongly, more of the portfolio participates in those increases. If share prices fall sharply, more of it is exposed to those falls.

The third portfolio has much less exposure to shares and considerably more in bonds and cash, so it may behave differently when stock markets move.

That doesn't make it risk-free.

Bonds can also rise and fall in value. More generally, investment returns aren't guaranteed. If the value of your investments falls, you could get back less than you originally invested, particularly if you need to withdraw your money while prices are lower.

Cash involves different risks. Although the amount held in cash doesn't normally fluctuate with investment markets, its purchasing power can fall over time. If inflation is higher than the interest your cash earns, the same amount of money will gradually buy less.

There is a trade-off.

Different asset allocations expose your money to different risks and different opportunities.

So asset allocation isn't simply about deciding how much risk to take.

It is also about deciding which risks it makes sense to take.

Why Not Invest Everything in Shares?

If shares offer the opportunity for long-term growth, why not simply put all your money into shares?

The answer starts with something outside the investment portfolio.

What is the money for?

Imagine you have £50,000 that you expect to spend within the next year.

Now imagine you have another £50,000 that you don't expect to need for another 20 years.

A substantial fall in stock markets next year could have very different consequences for those two sums of money.

If you need the first £50,000 to pay for something, you may have little choice about when to use it. If markets have fallen sharply, you may have to sell investments when their value is lower than it was before the fall.

The second £50,000 has much longer before it is expected to be needed. Short-term movements may therefore be less important, although having more time does not make investment risk disappear or guarantee that losses will be recovered, you may still get back less than you invested.

Same person.

Same amount of money.

Different purpose and different timescale.

Potentially a different asset allocation.

What Happens If Your Investments Fall?

Time is only part of the picture.

We also need to consider what a fall in value would actually mean.

Suppose two people both have investment portfolios worth £500,000.

Both portfolios fall by 20%, leaving each worth £400,000.

Yet the financial consequences could be very different.

One person may still be working, have substantial cash savings and have no plans to use their investments for many years.

The other may already be retired and relying on their portfolio to support their spending.

The investment fall is identical.

Its significance isn't.

This is why investment risk makes more sense when considered alongside the financial plan.

The important question isn't only:

How much could my investments fall?

It is also:

What would that fall mean for the things I need my money to do?

That can have an important influence on how much is held in different types of investments.

You Have to Be Able to Live With the Investment Strategy

There is another side to this.

How would you feel if your investments fell substantially?

Someone may have enough financial flexibility to cope with a large fall but still find the experience extremely uncomfortable.

An investment strategy can look perfectly reasonable on a spreadsheet. It still has to be lived through when markets are falling and the news is full of reasons to worry.

This is where your attitude to investment risk becomes important. You can read more about this in What Is Attitude To Risk?

How much risk you can financially afford to take and how comfortable you are experiencing investment losses are related questions, but they aren't quite the same thing.

Both can influence what mix of investments makes sense.

Asset Allocation and Diversification Are Not Quite the Same Thing

Asset allocation is closely connected with diversification, but the two terms don't mean exactly the same thing.

Imagine you owned shares in 1,000 companies spread across different industries and countries.

Your money would be much more widely spread than if you owned shares in a single company.

Yet your asset allocation could still be 100% shares.

Diversification is about spreading your investments so that you are not relying too heavily on one company, industry, country or type of investment.

Asset allocation describes how your money is divided between different types of assets, such as shares, bonds and cash.

The two ideas work together. Holding different asset classes is one way of diversifying because you are no longer relying entirely on one type of investment behaving as you hope.

Diversification cannot remove investment risk altogether, but it can reduce how dependent you are on one particular investment or part of the market performing well.

I explain this in more detail in What Is Diversification?

Your Asset Allocation Can Change Over Time

Your asset allocation can change even if you don't deliberately change it.

Suppose you start with £60,000 in shares and £40,000 in bonds.

Your asset allocation is 60% shares and 40% bonds.

If the shares then rise more in value than the bonds, the proportions might eventually become 70% shares and 30% bonds.

You haven't decided to invest more heavily in shares. The allocation has changed because the investments have performed differently.

This is sometimes known as portfolio drift.

If the intended allocation remains appropriate, the portfolio may be rebalanced by adjusting the investments back towards their intended proportions.

The purpose isn't to predict which investment will perform best next. It is to keep the portfolio reasonably aligned with the investment strategy it was designed to follow.

So What Is the Right Asset Allocation?

There isn't one asset allocation that is right for everybody.

• More shares aren't automatically better.
• More bonds don't automatically mean less risk.
• Holding more cash reduces some risks while introducing others.

The appropriate mix depends on what the money needs to achieve and when it may be needed.

It also depends on how much your money may need to grow to achieve what you want, what would happen if investment values fell and how comfortable you would be experiencing those falls along the way.

• Those considerations can change.
• Your circumstances may change.
• The purpose of the money may change.
• The time before you expect to need it may become shorter.

That is why asset allocation makes most sense as part of a wider financial plan rather than as an investment decision made in isolation.

It is tempting to start with a question such as:

What percentage of my money should I have in equities?

There isn't a universal percentage that answers it.

There is a more useful question to answer first.

What does this money need to do?

Once you understand that, the percentages start to have some meaning.

This article is for general information only and should not be treated as personal financial advice. The appropriate mix of investments will depend on your individual circumstances, objectives and attitude to investment risk.

Matthew Birkett
Chartered Financial Planner
Birkett Financial Planning