When I first started investing seriously in the early 1990s, I read a few books and the almost obligatory Investors Chronicle and made a few notes in the back of my investment notebook. Some years later, after the dust had settled from the so called dot-com crash, I re-read my notes and began to understand the concept of asset allocation. At the time, like many other small investors, I had been sucked into the technology bubble of the late 1990s - all of my investments were equities and included a rather high proportion of tech shares.
Asset allocation is really a question of looking at the possible options and deciding what proportion of your investments to put in each one. The usual classes of asset are equities, government bonds (gilts), corporate bonds and fixed interest securities, commodities such as gold and silver, property and finally, cash.
A classic allocation is 60% equities and 40% bonds. My current allocation is 60% equities and 40% corporate bonds, pibs and fixed interest. There is no such thing as a perfect asset allocation - each person should decide on the best mix, and of course, the mix between different classes of asset can vary over time.
One rule of thumb is to hold the same percentage of bonds as your age - so at age 30 years, it would be 70% equities and 30% bonds. At age 50 years, a 50:50 mix etc.
Tim Hale, author of “Smarter Investing” suggests 4% in equities for each year you intend to be investing - the remainder in bonds.
Another popular choice is the Harry Browne Permanent Portfolio allocation - 25% equities, 25% gilts, 25% gold and 25% cash. The portfolio is rebalanced once per year to restore any imbalance that has arisen as one asset class does better than another.
Personally, I’m not a big fan of gold, mainly because it does not provide an income - other people will hold a significant percentage in their portfolio as a hedge against currency devaluation.
Whatever allocation you may decide is right for your investment approach, the main point is that you have addressed the issue. Also, I wouldn’t get too bogged down with 2% or 3% in this class and 4% in another - a broad brush is going to do the job and will be easier to manage and rebalance.
Many private investors start off with good intentions, but get sidetracked by the latest trend - with me it was technology shares in the late 1990s - but it could be smaller companies, emerging markets, commodities and so on, ending up with a dogs dinner of a portfolio.
If I were in my 20s or 30s, I could well decide to choose 100% equities, after all, they are the most likely to provide the best return over the longer period. This is asset allocation - its just that I have chosen to allocate 100% to equities. Obviously there will be no need to rebalance.
Say I choose 50% equities, 25% gilts and 25% corporate bonds - and say at the end of the year equities have done very well and have increased to 60 % of the total portfolio value. This would mean the gilts and corp. bonds represent only 40%. The idea of rebalancing is to restore the original balance of 50:25:25, therefore I sell some of my equities and reinvest the proceeds into bonds and gilts. The overall value of the portfolio has increased but the original allocation percentages are always restored at regular intervals.
One of the benefits of spreading your investments across a number of different asset classes is the reduction of volatility. If you are invested 100% in equities and there is a sudden downturn in the markets, you could easily lose 20% or 30% of the value of your portfolio in a very short period of time - witness late 2008! However, if your investments are mixed between equities, gilts and other fixed interest securities, it is more likely the loss will be more like10% or 15% which should make it a little easier to ride out the storm.
With an ever increasing choice of low cost trackers - funds and exchange traded funds (ETFs), it is relatively simple to select a range of products to provide you with a fully diversified asset allocation to fit every possible option.
Vanguard are very popular and offer a good range of equity and bond trackers Vanguard trackers . They also offer the increasingly popular LifeStrategy range ( here ) which combine equities and bonds in one fund according to the level of equity exposure you require - furthermore, the fund is automatically rebalanced on a regular basis.
For more info on the full range of low cost trackers see the latest update on Monevator here
Asset allocation is a mechanism for balancing the elements of risk and reward and is one way of ensuring an element of diversification - in a future article, I will look at other ways to spread risk.