Why asset allocation matters
If all your ‘eggs’ were in the emerging markets shares ‘basket’ in 2010, what would your finances look like today? Here’s a practical example of why diversification is a key investment strategy
Published on 05 Nov 20204 minute read
Look at the portfolio of a successful investor and the chances are you’ll find a wide range of asset classes, typically including shares, bonds, alternatives such as property and cash. The way an investment portfolio is spread across different types of investments is called asset allocation.
Asset allocation is popular among investors because a diversified investment portfolio can achieve higher returns against a given level of risk: different types of assets respond to different factors, such as changes in inflation and interest rates, so their prices don’t always move in the same way at the same time. Asset allocation provides an effect that smooths out the big drops (or ‘volatility’) you’re likely to experience if you only invested in a single asset class.
For a practical example of why asset allocation is so important, let’s have a look at the returns of a single asset class, emerging market equities, throughout the past 10 years.
Each of the boxes in this chart represents a different asset class. The returns are scattered around, and each column (2010, 2011, etc.) shows you the returns of each asset class in that year.
The black line shows the performance of just one of these assets over the last 10 years: emerging market equities. Back in 2010, emerging market equities was in the top three assets invested in; however, only a year later it fell to the bottom of the class and was down over -17.5%, wiping out pretty much all the returns from the year before. It rocketed back up in 2012, and this up-down pattern carries on through the 10-year period.
Now you may say, ‘That’s fine, I’m getting good returns’. But what if you needed those funds in, let’s say, 2015 – five years down the line? You’ve had some good returns, but you’ve had some bad ones and you are sitting on a 10% loss because you’ve put all your eggs in one basket.
If you look at the broader picture, no asset class performs top of the class each year. It’s only by mixing and matching all these different assets together that you can smooth out that line, ending up with positive returns on an ongoing basis rather than these dramatic up-and-downs.
Different asset classes perform differently in different markets, so it really is key to make sure that you don’t put all of your eggs in one basket when it comes to investing.
Investing is for the long term
As you’ve seen from what happened at the beginning of 2020 with Covid-19, the unexpected does happen and it can have a really dramatic effect on markets. However, if you sold your investments prior to the Covid-19 crisis in March and tried and put your money back into the market just before we saw a rally before the end of April, nine times out of 10 you would have got that wrong. The reason for that is that the worst day and the best day of the market performance are clustered really closely together.
This is why your investment time horizon (the period where one expects to hold an investment for a specific financial goal) is key. If your time horizon is longer, you can afford to take more risk in your asset allocation – for example, if you’ve just started working and have many years to go until retirement – and hopefully, if you hold your investments over the long term and don’t get spooked or confused by the falls in markets, you could have good returns. Time is on your side, so you can ride out the ups and downs.
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