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Asset Allocation

One of the first and most important decisions we can make when investing is how much of our investment will go into different asset classes.

What is Asset Allocation?

“On average, 90% of the variability of returns and 100% of the absolute level of returns is explained by asset allocation” Roger G. Ibbotson
  • Asset allocation is the amount of a portfolio devoted to different asset classes
  • Asset allocation allows us to adjust the level of risk in our portfolio, and therefore expected return
  • We can consider three types of portfolios in general * Income portfolio – invested pre-dominantly in coupon bonds and some high dividend paying stocks (safer). Low risk, but also low return * Balanced portfolio- as the name suggests, a mix of income and growth assets. Moderate amount of risk * Growth- focused on long-term investments that are expected to appreciate in value. High risk, but also comes with higher returns

Asset Classes

  • One of the first and most important decisions we can make when investing is how much of our investment will go into different asset classes.
  • When we refer to asset classes what we mean is different types of assets that we can invest in such as cash, stocks, bonds, property etc. As was shown earlier, different asset classes have different levels of risk and expected return.
  • Investing more heavily in growth assets, stocks and property for instance, will tend to increase the expected return of our portfolio, but also will increase the standard deviation of our returns.
  • Adding in bonds and cash will reduce the risk and also lower the return. The composition of your portfolio in terms of the amount into each asset class will contribute far more to the eventual return you make then time spent picking individual assets!
  • This is why asset allocation is so important.
  • Two things you should consider when deciding on an asset allocation – Time Horizon and Risk Aversion

Quick Check

Exercise So, what is the ideal asset allocation for you?

Please review the narrated PPT, you can also find it as an attachment at the end of the course.

Narrated Asset Allocation PPT

which discusses the factors that determine what is a suitable asset allocation for you. Why asset allocation is one of the most important decision you can make

Time Horizon

  • Risky assets are more volatile year to year, but over longer periods tend to increase in value. Bank deposit values tend to be very certain. However, stock markets are viewed as having a 7-10 year cycle
  • Consider the graph on the next slide

TIME HORIZON

  • The longer time we have till we need our capital, the more risk we should take.
    • Longer time for prices to recover. Higher expected returns – although only expected, may not always pay off!
    • Over 10 years we would invest predominantly in stocks
  • Medium to long term (5-10 years) we would look at a balanced portfolio. Less then 5 years – income portfolio.

Risk Aversion

  • Risk aversion indicates how comfortable a person is with price drops
  • Why does it matter, consider an investor with 100% in stocks?
  • In 2020 as a result of the COVID pandemic, markets globally experienced big losses. Between 14 Feb 2020 and 20 Mar 2020 S&P500 lost 31%. If you had $1,000 invested on 14 Feb 2020, you had $681 one month later
  • What would an investor do?
  • Risk aversion impacts how much risk we put in our portfolio. The more risk averse we are, the smaller the price swings we can tolerate. Therefore the smaller the proportion of risky assets like stocks. A severely risk averse person should invest in an income portfolio irrespective of time horizon. Focussed heavily on capital preservation, the downside is little capital appreciation.
  • A person with low risk aversion could accept larger price movements. More suited to a growth portfolio depending on time horizon. If investing for a short time horizon should still take a safer portfolio!

Activity

Determine what your top financial goal is that will require you to invest money i.e. not paying off debt, but rather saving for something in the future be it further education, car, holiday, house or retirement. Based on this financial goal, what is your time horizon?

  • Now go take the quiz to determine your risk tolerance. – Based on these factors, what do you think is a good asset allocation for your investments?
  • Share your goal and asset allocation in the discussion section.
  • P.S. sharing goals increases our sense of accountability and makes it more likely that we will achieve them so don’t be shy!
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How to Invest: Modern-Day Financial Decisions

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