What is asset allocation and why is it important?

What is asset allocation?

Asset allocation refers to how a portfolio is divided among different categories of assets. These categories – commonly known as asset classes – typically include equities (shares), fixed income (bonds), commodities, real assets such as property, cash or cash equivalents and digital assets such as cryptocurrencies.

Each asset class tends to behave differently under varying market conditions. Shares, for example, may offer higher growth potential but come with greater price volatility. Bonds are generally considered more stable but may offer lower returns over time. Cash can provide liquidity and security, but its value can be eroded by inflation. Cryptocurrencies, such as Bitcoin and ether, represent a newer asset class – one that some investors include as a portion of a broader portfolio for potential diversification benefits, though they carry significant risk.

By combining asset classes that behave differently from one another, investors could reduce the impact that any single underperforming asset has on their overall portfolio. Asset allocation is not a fixed decision – it should evolve as markets change, new asset classes emerge and an investor's goals and circumstances shift over time. Here is a chart demonstrating an example of a portfolio split across equities, bonds, cash, commodities, and crypto: 

What are the advantages and disadvantages of asset allocation?

Like any investment strategy, asset allocation has both strengths and limitations. Understanding both sides could help investors apply it more effectively and with realistic expectations.

What are the main types of asset allocation strategies?

What factors influence asset allocation decisions?

Several factors typically shape how a portfolio is allocated:

1. Risk tolerance: the level of risk an investor is comfortable with – including the possibility of losing some or all of their invested capital.
2. Time horizon: how long an investor plans to hold their investments before they need access to the funds.
3. Investment goals: whether the focus is on capital growth, income generation or capital preservation.
4. Market conditions: broader economic factors, interest rate environments and market cycles can all influence how different asset classes are expected to perform.
5. Liquidity needs: some investors may need ready access to a portion of their funds, which could influence how much is held in liquid assets such as cash or short-dated bonds.

How does age affect asset allocation?

Age is one of the most commonly referenced factors in asset allocation discussions, and for good reason. As an investor's time horizon shortens, the ability to recover from significant market downturns diminishes.

A younger investor with decades ahead of them may be better positioned to tolerate short-term volatility in pursuit of longer-term growth. As a result, their portfolio might carry a higher weighting towards equities. As that same investor approaches retirement or a major financial milestone, they may gradually shift towards a more conservative mix – increasing exposure to bonds and cash to help protect accumulated wealth.

This gradual shift is sometimes referred to as a "glide path" – a progressive reduction in portfolio risk over time. Some managed fund structures automate this process by adjusting asset allocation based on a predetermined retirement date.

It's important to note that age is just one variable. Individual financial circumstances, income stability and personal goals all play a role in determining the right allocation at any given stage of life.

What is portfolio rebalancing and how does it relate to asset allocation?

Over time, market movements cause the actual weighting of assets in a portfolio to drift away from the original target allocation. For example, if equities perform strongly over a period, they may come to represent a larger share of the portfolio than intended – increasing overall risk exposure beyond what was originally planned.

Rebalancing is the process of returning the portfolio to its target allocation, typically by selling assets that have become overweight and purchasing those that are underweight.

When should you rebalance?

There is no universal rule, but two common approaches are:

• Calendar rebalancing: reviewing and adjusting the portfolio at set intervals – such as quarterly or annually – regardless of how much it has drifted
• Threshold rebalancing: triggering a review only when an asset class moves beyond a defined percentage from its target – for example, if equities exceed their target weighting by more than 5%

Both methods have trade-offs. Calendar rebalancing is straightforward but may lead to unnecessary transactions. Threshold rebalancing is more responsive but requires closer monitoring.

Rebalancing may involve transaction costs and potential tax implications, depending on the jurisdiction and investment vehicle. These factors are worth considering when deciding how frequently to rebalance.

Common asset allocation mistakes to avoid

Even investors who understand the principles of asset allocation can fall into patterns that undermine their strategy. Some of the more common pitfalls include:

Failing to rebalance

Without regular rebalancing, a portfolio can drift significantly from its target allocation – often increasing risk exposure in ways the investor may not have intended. This is particularly common during extended bull markets, when rising equity valuations can quietly shift the balance of a portfolio.

Overconcentration in familiar assets

There is a natural tendency to favour investments that feel familiar – for example, weighting a portfolio heavily towards domestic shares or a particular sector. This bias can reduce the diversification benefits that asset allocation is designed to provide.

Chasing performance

Adjusting asset allocation based on recent performance – moving into asset classes that have risen sharply or away from those that have fallen – is a form of performance chasing. This approach risks buying high and selling low, which runs counter to the principles of a disciplined allocation strategy.

Ignoring changing circumstances

A target allocation set years ago may no longer reflect an investor's current financial situation, goals or risk tolerance. Life events such as a change in income, a shift in financial goals or approaching retirement are all reasons to revisit the underlying allocation strategy.

How to build an asset allocation strategy

While the right approach will vary from person to person, a structured asset allocation process typically involves the following steps:

1. Define your goals: clarify what you are investing for – whether that's long-term wealth building, generating income or preserving capital – and over what timeframe.
2. Assess your risk tolerance: consider how much short-term volatility you are prepared to accept in pursuit of your longer-term objectives.
3. Choose your asset classes: decide which asset classes to include and in what proportions, based on your goals, time horizon and risk profile.
4. Select your investments: within each asset class, determine how to build exposure – whether through individual securities, funds, ETFs or other instruments.
5. Monitor and rebalance: review your allocation on a regular basis and rebalance when it drifts meaningfully from your targets.

This process is not a one-time exercise. As your circumstances and goals evolve, so too should your approach to asset allocation.

FAQs about asset allocation

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