What is asset allocation?

As an investor, your asset allocation is the spread of your portfolio amongst the core asset classes. Typically, these asset classes are equities, bonds, property and alternatives. Planning your asset allocation at the outset gives you a firm foundation to both build and maintain your portfolio over time, meaning that you’re less likely to make inconsistent investment decisions. Let’s look at some of the ways you can get started.

Your asset allocation is the framework for your portfolio.

Many professional and experienced investors plan their strategic asset allocation at the outset when building their portfolio. This will typically be their long term average target asset allocation and will be tied to their risk tolerance and risk capacity, as well as their investment objectives. For example, if an investor has two portfolios, one for retirement in 20 years time and another for, say, buying a holiday home in 5 years time, you would expect these portfolios to have a different asset allocation as they have different objectives.

Typically, your asset allocation will lay out a target percentage to be assigned to each asset class. For example, the traditional “60:40” portfolio would have an asset allocation of 60% equities, 40% bonds. The investor can use these targets to invest new capital (e.g. if you top up your portfolio and you’re underweight bonds, you might use the cash to buy more bonds to bring your allocation back to 60:40) or to rebalance periodically (e.g. once per quarter, you might check in and adjust the portfolio back to the target 60:40 split).

But if you don’t yet have an asset allocation planned, how can you know where to start?

Equities are the traditional driver of risk within your asset allocation.

There’s an old fashioned approach to asset allocation, back from when investors typically only had their pensions to worry about. The theory was that the equity portion of your asset allocation should be 100 minus your age. So for example, if you were 40 years old, you should have an asset allocation with 60% invested in equities.

The logic behind this is that equities are the traditional driver of risk within a portfolio’s asset allocation; the higher your equity allocation, the more the valuation of your portfolio is likely to move up and down in line with the markets (i.e. the more volatility you’ll experience). If you’re younger, you can afford to have more risk within your asset allocation as you have a longer time horizon until you retire. Conversely, if you’re older, you’re closer to the point at which you might need to access your funds (if you’re not drawing from your portfolio already) and so you would expect to have a more conservative asset allocation.

In 2023, things aren’t quite so straight forward. Investors aren’t just managing their pensions, but ISAs and GIAs too. And we’re not just investing for retirement either! The good news is the concept behind the ‘100-Age’ rule still works. At its core, the method links your asset allocation to your time horizon, or how long you’re investing for. This dictates, to some extent, your risk capacity. The longer your time horizon the more adventurous your asset allocation can be. (Need a refresh on risk capacity and risk tolerance? We have an Insight for that here).

Risk can be found in every part of your asset allocation.

Although they are the traditional risk asset, equities aren’t the only tool you have as an investor when it comes to changing the risk of your portfolio. There is a spectrum of risk with every part of your asset allocation. Within bonds you can explore high-yield or emerging market debt to increase your risk. Within property you can explore real estate investment trusts (REITs) rather than pure ‘direct’ property.

What we’re trying to say is that there are levers to be pulled to control your risk exposure whatever asset class you’re considering. Knowing your starting point and where you want to get to (i.e. your current asset allocation and your target asset allocation) is the one of the best ways to keep those risks under control. You can be more measured with making decisions, for example exploring high yield debt within your bonds allocation, if you are confident that your overall asset allocation is appropriately balanced.

There is no perfect formula for setting your asset allocation.

I wish that I could provide the perfect asset allocation here in this article so that you could jump straight to building your portfolio. But unfortunately, I can’t do that. There are so many variables that go into determining whether an asset allocation is right for an investor and it ultimately comes down to their own personal circumstances and investment objectives. It’s also worth remembering that an individual’s asset allocation might change over time, perhaps as they get closer to their investment goals or as their circumstances change.

The good news is that there are lots of example asset allocations available for free! For example, the MSCI index publish the Personal Investment Management and Financial Advice Association (PIMFA) Private Investor Index Series. “The series consists of five composite indices designed to represent the weightings … of selected multi-asset-class strategies”. There are 5 PIMFA indices; Conservative, Balanced, Income, Growth & Global Growth. The indices are based on those 5 portfolio ‘types’ and provide example an asset allocation for each.

There are also many articles from news and information outlets which contain examples of different asset allocations. We really like this Investopedia article which discusses the risk/return trade-off and provides 5 example asset allocations based on risk. You can even look at the websites of investment managers, IFAs and robo-advisers, some of whom publish sample portfolios.

You can outsource asset allocation decisions.

If you’re still not sure what your asset allocation should be, or if this isn’t something that you want to manage on an ongoing basis, you can always consider multi-asset funds. With multi-asset funds, the managers will allocate capital across all asset classes, rather than focusing on a single area (e.g. equities, bonds, property). Typically the manager will have a target range for some or all elements of the asset allocation, e.g. 40-60% equities, and they will create a balanced portfolio within these targets.

Multi-asset funds can be a great option for investors who don’t have the time, confidence or desire to choose and maintain their own asset allocation. If you choose to go down this route, we would still recommend diversifying your exposure to more than one multi-asset fund, rather than putting your eggs in one basket.

Whatever asset allocation you decide is best, deciding your allocation at the outset makes it easy to narrow down your investment search and to be confident that you’re achieving the right balance with your wealth. At TILLIT, you can browse our curated Universe of funds, investment trusts and ETFs based on asset class, investment style, region, fund structure and many more options, making it easy to find the right funds for your portfolio.

Date of publication: 10th February 2023