In early March 2020, the major outbreak of the COVID-19 virus around the world caused the global stock market to suffer 30% losses overall, hurting a huge proportion of stock market players. However, with the rise of uncertainty, gold, a prominent safe-haven asset, has experienced price spikes. This inverse relationship between gold and the stock market has revealed the importance of a common investment strategy — asset allocation.
Asset allocation is the process of determining the mix of assets in an investment portfolio. It is a key ingredient for an investment strategy to succeed as it will help investors to achieve their investment goals by reducing risk. With proper asset allocation, individual investors will be able to minimize risk on their investment and infuse more certainty on achieving their financial goals. Depending on personal needs, the asset allocation will also help secure investors with sufficient liquidity for their financial obligations or goals.
However, there is no simple formula to find the right asset allocation for every individual as it varies from person to person. In general, an ideal allocation strategy can be built by considering the individual’s financial situation, including time horizon, level of risk tolerance and investment goals.
Common Asset Classes
A wide array of investment products exists in the current financial market. The most common asset class includes equities, fixed income as well as cash and equivalents. There are also other asset categories, namely alternative investments, including commodities, real estate and art pieces which some investors may hold in their portfolio. In this article, the discussion will be mainly focused on the common asset class.
Table: Comparison for stock, bond and cash
Probably the most well-known investment. A shareholder will be able to make profit through potential capital growth and dividend income. Given that the stock market is highly volatile, this asset is better suited for investors with high risk appetite. As a return for bearing a higher risk, the potential return for the stock market is also relatively higher compared to other major asset categories.
A bond is a fixed income asset that is issued by the government, corporations or municipalities to raise funds for specific purposes. Investing in bonds means an investor is lending money to these entities for a period of time in exchange for interest payments. In general, bonds, especially government bonds, are less volatile than stocks, but potentially generate more modest returns.
Cash and equivalents such as saving deposits, money market funds and treasury bills are known as the safest investment with minimal risks. These investments offer lower return among the common asset categories but also provide higher liquidity in which investors are allowed to withdraw cash relatively easily. However, investors who put their money in cash investments with a fixed rate of interest payment as return, will be exposed to inflation risk. They may lose purchasing power if the rate of return of the money invested does not pick up with inflation rate.
Key Consideration for Choosing Your Ideal Asset Allocation
Asset Allocation by Investment Goals
To get started, investors need to consider their current financial situation and how much they can afford to put into their portfolio, followed by their desired level of return to fund their goals. For example, a person with a goal of purchasing a house in 10 to 15 years would likely be implementing more aggressive investing plans by investing in riskier assets such as stocks, given that the time horizon is longer. Therefore, different goals will require different investment horizons to achieve. This affects risk tolerance.
Asset Allocation by Time Horizon
The time horizon can be explained as the period of time that one expects to achieve a particular financial goal through holding an investment portfolio. In simple words, it is the duration of an investor’s investment. Most of the time, it centres around the goal of the investment such as retirement funds, education funds and travel funds. Different time horizons will lead to different levels of risk tolerance. Generally, investors with short-term goals tend to avoid taking riskier investments in their portfolios, while long-term investment strategies may encourage investors to invest in a more volatile portfolio as there is more room for economic conditions to change over time.
Asset Allocation by Risk Appetite
Risk appetite, also known as risk tolerance, refers to how much an investor is willing and able to lose his or her initial investment in anticipation of getting a higher return in the future. Among the different types of investment risks, market risks (which include equity risk, interest rate risk and currency risk), liquidity risks, reinvestment risks and inflation risks have received more attention from the majority of investors. An investor’s risk appetite can help in determining the asset mix in the portfolio. Generally, an investor with a higher risk tolerance, will include riskier assets such as stocks and hold a lesser portion of safer assets such as bonds and cash in the portfolio, expecting a higher return in a shorter period of time. On the other hand, a conservative investor will tend to look for less volatile assets to hold in order to preserve their original investment capital.
After designing and implementing specific asset allocation strategies, rebalancing the portfolio is crucial to ensure the overall strategy works well. Since each asset class will perform differently depending on market conditions, rebalancing has to take place in order to bring the portfolio back to its original strategic mix over time. By doing so, investors are ensuring that their investments are still aligned with their investment goals.
Rebalancing can be executed in different ways such as Calendar Rebalancing and Percentage-of-Portfolio Rebalancing (also known as Tolerance Band Rebalancing). The Calendar Rebalancing method is relatively easy to implement as it requires lesser knowledge and monitoring. To use this approach, investors will need to analyse and adjust their portfolio to the original allocation or new allocation if needed on a regular time interval such as every three months, six months or twelve months with the consideration of time constraints and transaction costs.
On the other hand, Percentage-of-Portfolio Rebalancing is a more intensive approach as compared to Calendar Rebalancing. This strategy involves the process of determining the tolerance range for each asset class in a portfolio in terms of change in weightage due to price volatility.
After determining an ideal mix of assets, investors can also improve their portfolio through further strategies such as diversification within the asset classes which might be able to further reduce the impact of specific market volatility. For instance, with the capital assigned to the stock market, investors can invest a relatively high percentage of capital in blue-chip stocks which provide more price stability and small amounts of capital in high volatility stocks. For those with a smaller capital, Exchange Traded Funds (ETFs) will also be able to help them in achieving this portfolio diversification effect. Further diversification can be achieved by allocating capital across more equity funds such as global equity funds.
There are many other tools that can be used to perform asset allocation. For example, some investors prefer to determine an appropriate asset allocation ratio through rule of thumb such as Rule of 100 which suggests investors to subtract their age from 100 in order to know how much they should allocate in equities. However, many of the traditional asset allocation methods have been criticized for utilising inadequate considerations and factors. With digital transformation, platforms such as robo-advisors, also referred to as a computerized investment manager, will be able to take into consideration more personal factors and other relevant information in the process of creating an asset allocation strategy. Therefore, asset allocation will continue to be a key component in a successful investment strategy for many investors but will move towards a more digitalized method.
Researcher: Evon Chew
Reviewer: Millen Lau
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