A step-by-step guide to asset allocation

Your overall asset allocation needs to reflect your future capital or income needs, the timescales before those capital sums are required, or the level of income sought, and the amount of risk you can tolerate.

No two investors’ allocations will be the same but, as a general rule, the more assets you can add to a portfolio using low-cost funds, the lower the volatility and the smoother the returns.

We have shown some typical asset allocations for different objectives, below, and examples of the fund holdings used to achieve them – for illustration purposes only.
1. Set your
financial planning objectives

Financial planning objectives can include providing additional pension income (see also Part One of this series at www.ft.com/diyfinancialplanning), paying for children’s education or property deposits, or meeting care fees – so you may need to use different asset allocations at different times, to match these liabilities.

For example, building up a lump sum over 20 years will require a higher allocation to long-term growth investments, such as equities. However, providing income will require equities, high-yield bonds and gilts.

“It’s all about asking: what is your objective,” says Matthew Merritt, head of investments strategy unit at Insight Investment. “Is it achieving a certain return, or matching a liability stream? Liability-driven investment is the same for an institution as it is for a private investor getting a kid through college.”
2. Set your strategic allocation

A strategic asset allocation is simply the mix of assets to be held in a portfolio for the term of the investment – to achieve a target level of risk and return.

For example, a simple strategic allocation for a 20- year term might be 50 per cent equities, 25 per cent bonds, 15 per cent cash and 5 per cent in both commodities and hedge funds. But, depending on how actively you want to manage your portfolio, you can also use tactical asset allocations in the short term, to exploit temporary economic or market conditions and boost returns. For example, a 5 per cent allocation to commodities may be increased in times of constrained supply – but revert to the normal strategic level once short-term profits are achieved.
3. Add assets to build up your portfolio

If you already hold shares and equity funds, you can simply buy exposure to the other assets needed to achieve your target allocation, and geographical spread. By adding assets with low correlations to your existing holdings – such as bond funds and exchange traded commodities – you will reduce overall portfolio volatility and generate smoother returns.

This can be done at low cost through a discount broker service, for a flat fee of £10-12 per share or fund added, with no initial or administration charge on the funds.

Over the long term, adding assets can enhance returns. For example, a diversified portfolio returning a steady 5 per cent a year will outperform a less well diversified portfolio returning 3 per cent one year and 7 per cent the next – even though the average annual return is the same.

“Open yourself up to broadest opportunity set that you can,” advises Merritt. “It’s not just about equity, government bonds, and property. Consider absolute return-style vehicles that have a different risk/return trade-off, commodities, and other opportunistic investments. Think about diversification not just in terms of asset class and geography but also in the way you manage money. Give money to different fund managers – some active, some passive.”
4. Monitor your asset allocation regularly

An asset allocation may need to be changed over time, for two reasons: rises in the value of assets can increase the volatility of a portfolio, and age can reduce the risk tolerance of an investor – especially in the years before retirement.

To ensure higher-risk assets do not dominate a portfolio, make sure you rebalance your portfolio annually, or when any one asset rises in value by, say, 20 per cent.

Vanguard, the fund manager, has found that, over the long term, a portfolio split 60:40 between equities and bonds but never rebalanced would have gradually drifted towards a more volatile split of 90:10 – because shares historically outperformed bonds.
5. Rebalance your portfolio

Rebalancing simply involves selling some assets that have risen in value and reinvesting the proceeds into those assets that have fallen below their target allocation.

For example, a portfolio that starts with £10,000 in equities and £10,000 in bonds may end the year with the equities up 10 per cent and the bonds unchanged – a 5 per cent return overall. So, to rebalance, you sell £500 of equities and buy £500 of bonds. After paying dealing charges of £10 on the two transactions, the portfolio is still split 50:50: £10,490 in equities, £10,490 in bonds.
6. Consider ‘lifestyling’

To ensure market volatility does not reduce your portfolio’s value just before the money is needed – for example, to provide a lump sum – you should consider gradually moving out of higher-risk assets, such as equities, and into lower-risk assets, such as cash and government bonds, before the money is needed.

This process, known as lifestyling, aims to reduce the volatility in a portfolio over a period of time.

For example, investors in their 30s can afford to hold more equities as they can ride out price fluctuations over time – but investors in their 50s cannot afford as much equity exposure as they have less time to recover from sharp falls.

Lifestyling can be carried out manually, by selling risky assets and holding the proceeds as cash or in government bonds (see “Rebalancing” above). Or you can use target date or “lifecycle” funds, which automatically change their asset allocations to accumulate capital gains in the early years and then protect them to deliver a lump sum, or generate income, on a specified target date.

Target-date funds are now offered by fund managers Vanguard and Fidelity, and allow investors to choose a fund with a target date nearest to when they will need to drawdown capital or income.

For example, a 30-year-old planning to retire in 35 years’ time might choose a 2045 fund. However, regulators in the US have expressed concern about the wide variation in performance between funds with the same target date.