Asset allocation is simply, the mix of different asset classes in an investor's portfolio - the percentage split between cash, bonds, property and shares.
We have come to learn over the years that there can be no preordained asset allocation formula.
Everybody has different individual needs and risk tolerance, so everybody's asset allocation will be different.
The public is bombarded by conflicting investment advice, and small investors find it difficult not to
follow the herd into the latest top-performing asset class. With great regularity, the public can be relied upon to buy last in the bull market and sell last in the bear market.
Investors' herd behaviour means they often ignore what should be the most important factor determining which assets to hold, the return needed from the investments and their level of risk tolerance. It is these two elements that should guide asset allocation.
Unfortunately, most people use their emotions when making decisions about investments rather than pure logic. Small investors generally buy when an asset has already gone up in price.
Warren Buffett, the legendary US investor, has been trying to drum the same message home for years in his annual letters to shareholders in Berkshire Hathaway. He said in 1978 that investors have a tendency always to "look in the rear-view mirror," and have an unwillingness to choose an appropriate asset allocation mix for their individual circumstances.
Inexperienced investors routinely hold portfolios dominated by one asset class - generally cash or shares. This narrow focus is common, and dangerous!
An example is a client we had in the U.K who, after working for British Telecommunications for many years, held a portfolio of exclusively BT shares. The risk of holding shares in just one company is huge and not justified by the expected return.
Research on behalf of Fidelity Investments found that, 61 % of savers who have held their
investments for 10 years or more, have never changed their asset allocation. This was even though more than half of all the investors were concerned about their exposure to risk.
This shows that most investors do not refer back to their original savings objectives, and change their
asset allocation as their circumstances and needs change. As an investor nears retirement or any other savings goal they might have, they need to think about reducing their exposure to the risks of equities and decreasing the likelihood of a sudden loss of value at the time they need the money most.
Constantly shifting your money from one asset to another is not only expensive and time-consuming, but almost guaranteed to make you lose out. Market timing is notoriously difficult to get right and, anyway,
is not the most important factor in deciding how well an investment does.
The long-term performance of investments is much more likely to be determined by asset allocation than by any other factor.
Most investors are unaware of this and tend to spend more energy seeking out the fund manager with the best performance record or the mutual fund/unit trust with the lowest charges rather than focusing on getting the right asset mix to meet their goals.
Getting the mix right is not easy. Investors must first decide what expected return their financial goals require. Goals may include funding retirement, paying school fees or buying a house.
The next step is to understand how much risk you are prepared to take. Ask yourself some searching questions about how much you would be prepared to lose and realistically what you need to get back from your investment. Then, a portfolio can be constructed which meets your individual needs.
The portfolio's mix between the different asset classes will change over time as the financial goals approach, but changing assets will be determined predominantly by your individual circumstances rather than by market movements.
Asset allocation should impose a control mechanism on your portfolio.