Asset Allocation Matters

Allocating assets properly and rebalancing regularly help investors remain focused on their long-term investment goals.

Asset allocation offers investors a powerful investment advantage as it enables investors to achieve their financial goals when practiced properly. By creating a proper asset allocation plan and rebalancing on a timely basis, investors can manage their investment portfolios with discipline and consistency.
Asset Allocation – Choosing The Optimal Mix
Asset allocation refers to allocating an investor’s investments across different asset classes, which is determined according to their investment goals, time horizon and risk profiles. As asset allocation is an important factor which affects their investment returns, investors should ensure that the asset allocation chosen best suits their needs.
In general, an investor aims either for capital growth or regular income over the medium to long-term. Investors whose objective is to pursue capital growth can allocate a larger portion of their investment portfolios in equity funds. Equity funds which focus on achieving capital growth are suitable for investors with an aggressive risk-reward temperament as equities offer investors higher returns over the long term albeit with higher risks. A long-term horizon of more than 5 years will enable investors to have more time to ride out market fluctuations over the investment period. In comparison, investors who seek regular income can allocate a larger portion of their investment portfolios in bond funds. Bond funds are suitable for investors with conservative risk-reward temperament. As bond funds provide more stable albeit lower returns, they are also suitable for investors who require recurring income to meet regular living expenses or who need to maintain some safety of their principal investments.
Ultimately, investors’ risk appetite influences the asset allocation proportions that they would choose. An investor with a conservative risk profile may opt for an asset allocation comprising 40% equity funds and 60% bond funds (Refer to Figure 1). Likewise, an investor with a moderate risk profile may invest 60% in equity funds and 40% in bond funds (Refer to Figure 2) and an investor with an aggressive risk profile may prefer an asset allocation that has a higher weighting to equities such as 80% equity funds with the balance 20% in bond funds (Refer to Figure 3).
Figure 1: Asset Allocation for Conservative Investor
Figure 2: Asset Allocation for Moderate Investor
Figure 3: Asset Allocation for Aggressive Investor
Rebalancing Regularly Keeps Portfolio On Track
Market movements can cause the asset allocation of an investor’s portfolio to change from the initial targeted allocation. Consequently, assets that have performed well become a bigger piece of the pie, while relative weightings of other assets decline accordingly. The asset allocation of the portfolio is then no longer optimal to the investor’s investment objective and risk profile. During periods of market uptrend, equity exposure in the portfolio is increased and the bond weightings are proportionately reduced. Thus, an investor’s equity exposure has exceeded a level consistent with his risk tolerance. The portfolio would then have a higher volatility than expected. The investor needs to reduce the proportion of the equity funds and increase the proportion of bond funds to rebalance the asset allocation accordingly.
However, during periods of market downtrend, the proportion of equity funds in the portfolio are reduced, resulting in higher weighting of bond funds. Thus, the investor needs to increase the ratio of equity funds to rebalance the asset allocation to its original proportion.
Therefore, to maintain their asset allocation, investors need to rebalance periodically once or twice a year to ensure their portfolio is in tandem with their investment goals, risk profile and time horizon. This practice will allow investors to remain focused on their long term investment goals, regardless of market movements.
Investors often allow their emotions to get the best of them when it comes to making financial decisions. They get fearful and anxious when the markets do not move in tandem with their expectations. Investors generally find it easy to stick to their investment strategies in a market uptrend, but face difficulties in sustaining their plans and controlling their emotions in a market downtrend. This eventually leads to the abandonment of investment plans and panic selling. By practising asset allocation and periodic rebalancing, investors can attain self-discipline and consistency with their investments in both good and bad times without being emotionally affected by market fluctuations. Proper asset allocation will give them the discipline to maintain their investment strategies especially in times of market turmoil.
Asset Allocation Matters A Lot
Having a defined approach to asset allocation will put investors on track to achieve their financial goals by establishing a framework that guides their investment decisions. Discipline and focus provided by the right asset allocation strategy and periodic rebalancing can reduce anxiety and stress associated with making investment decisions. In short, investors need to adopt a disciplined approach to asset allocation as it empowers them to stay the course, regardless of market conditions.
Source: The Bulletin, July/August 2012