15.7 Asset allocation

Allocation of assets

Asset allocation is a very important tool in building a diversified portfolio. Or in other words, this is the task of figuring out how much of your portfolio will be invested in different asset classes such as stocks, bonds or cash. For example, if stocks have historically returned 10 per cent per year and bonds have returned 5 per cent per year, a mix of 50 per cent stocks and 50 per cent bonds would be expected to return 7.5 per cent per year. An asset class comprises securities that have similar characteristics, attributes, and risk/return relationships. A broad asset class such as bonds can be divided into smaller asset classes such as treasury bonds, corporate bonds and high-yield bonds. The asset allocation decision is not an isolated choice. Rather, it is a component of a portfolio management process. Much of an asset allocation strategy depends on the investor’s policy statement, which includes the investor’s goals or objectives, constraints, and investment guidelines. How individuals’ structure their financial plan should be related to their age, financial status, future plans, risk aversion characteristics and needs. Before embarking on an investment programme, we need to make sure that our other needs are satisfied. No serious investment plan should be started until a potential investor has adequate income to cover living expenses and has a safety net, in case the unexpected occur. Now with regards to asset allocation strategy, we need to remember that generally the younger you are, the more risk you can afford to take. As you get older and closer to retirement, you will probably be less interested in the growth of your portfolio and more interested in capital preservation or the conservation of wealth, thereby protecting the value of your portfolio from any declines. Preserving your portfolio as you reach your desired retirement age becomes more important since a large decline in the value of your holdings can affect your retirement lifestyle, or even make it impossible to retire according to your plans.

Asset classes exhibit different market dynamics and different interaction effects. Thus, the allocation of money among asset classes will have a significant effect on the performance of the fund. A sample Merry Lynch recommendation table is provided as reference. As discussed earlier, a portfolio consisting different stocks alone may be part of an individual’s investment plan. Then in that case we need to diversify the stocks based on categories or sector.

FORMS OF COMBINATION OF PORTFOLIOS IN INVESTMENT