What Is Asset Allocation? Why Is it Important?
Having a proper asset allocation is by far the most important part of any investment portfolio. Research has shown that good asset allocation is key to the long term success of any investment portfolio.
What is asset allocation?
Essentially, asset allocation is how you divide your investments between the different asset classes (e.g. cash, bond, property and share). An older investor may have a lower allocation to more risky assets like shares, while a younger investor may prefer a higher allocation to such assets.
Why is it important?
Since different asset classes react differently to changing market and economic conditions, having an appropriate asset allocation can help you manage the ups and downs of financial markets.
For example, an investment portfolio (e.g. Portfolio A) with a larger allocation to cash (e.g. 80%) than shares (e.g. 20%) will perform much better in bad market conditions compared to a portfolio with higher shares allocation. The same Portfolio A would however underperform a portfolio with 100% shares during a “bull run” (or good share market conditions).
How to determine the right asset allocation for you?
There is no right or wrong answer to this question, as the appropriate asset allocation for you depend on a number of things, including:
- Your attitude toward risks / uncertainty – how much short-term losses can you handle?
- Your investment time horizon – how long can you put away your money for?
- Your individual circumstances – how much future financial commitments do you have?
As a rule of thumb, the lower your tolerance toward risks and the shorter your investment time horizon, the smaller your allocation should be in risky assets such as shares and property.
How does age come into play?
As you grow older, it is important that your asset allocation adjusts to reflect the change in circumstances. If you continue to invest like how you were 10 or 15 years earlier, you may be undertaking undue amount of risk.
Generally, your asset allocation should gradually change towards a more conservative one as you age, with more allocation in safer assets (like bonds and cash), and less in risky assets (like shares). As you reach retirement age, it is important to have enough income generating assets in your portfolio (e.g. cash, bonds and property) to replace the loss of income.
Some example investment portfolios
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This article was first published in 2012 and has been updated for freshness, accuracy and comprehensiveness.