More than eighty percent of the returns you make on your investments is determined by your asset allocation, which is the allocation of your portfolio to the major asset classes – bonds, equities, cash / savings and possibly real estate. It is therefore very important that you carefully consider the right asset allocation for you.
The amount of money you put into each category is largely determined by your risk profile, investment horizon and the goals you want to achieve. The longer your investment horizon – a pension for 30 years, for example – and the higher the return you need to achieve your goals, the more aggressive you can allocated among different assets. As long as it is within your limits of accepted risk, of course.
From defensive to offensive
Roughly speaking, you can characterize the different risk profiles as follows:
- Defensive: Focus on bonds, which are less volatile over time than stocks. The share of stocks in the portfolio is limited, and so is real estate. Also, a large amount of cash can be held if markets are very volatile.
- Neutral: the share in stocks and the share in bonds are fairly balanced. If there is real estate in the portfolio, the risk profile is usually more defensive. Again, the portfolio often holds some cash – the amount of cash can be increased if the market requires it.
- Offensive: Focus on stocks which show more violent movements than bonds, but should provide higher returns over time. The higher volatility, and thus the higher risk, of stocks gives them a higher expected return. The percentage of bonds is limited, but the share of real estate is probably somewhat larger than in other risk profiles. Aggressive investors may hold cash too, but tend to be less likely to choose this refuge.
Can the asset allocation for different risk profiles be indicated in precise percentages? Not really. Even professional asset managers all have different percentages in their model portfolios.
The following ranges are typically used by large banks. Alternative investments include real estate, hedge funds and / or commodities. The first percentage indicates the minimum, the second the neutral, and the third percentage indicates the maximum share of the asset in a portfolio. For example, for a very defensive portfolio the maximum share of cash equivalents in the portfolio would be 60%.
|Shares||Bonds||Alternative investments||Cash equivalents|
|Very defensive||0% 0% 10%||40% 90% 100%||0% 5% 5%||0% 5% 60%|
|Defensive||0% 15% 30%||30% 70% 85%||0% 10% 20%||0% 5% 70%|
|Moderatley defensive||10% 30% 50%||20% 55% 70%||0% 10% 20%||0% 5% 70%|
|Moderately offensive||20% 50% 70%||10% 35% 55%||0% 10% 30%||0% 5% 70%|
|Offensive||30% 70% 90%||0% 15% 40%||0% 10% 30%||0% 5% 70%|
|Very offensive||40% 85% 100%||0% 0% 25%||0% 10% 30%||0% 5% 60%|
Allocation may change
To make it even more complex: asset allocation will change over time. As your investment horizon gets closer you would do well to reduce some risk (assuming you are on track to achieve your goals). It could be that you shift from an offensive portfolio to a neutral or even a defensive portfolio.
Or maybe you had some good results in the past which has already brought you closer to your goal than you had planned allowing you to start reducing risk. In investment jargon this is called dynamic asset allocation. There is also something called tactical asset allocation; which has to do with making interim changes to your allocation because you have a certain vision of the market. For example, if you expect or fear an interest rate hike, or if you believe shares to be very expensive or very cheap.
Mind you, once you start dealing with tactical allocation, you are basically actively investing. This requires a more responsive attitude than choosing one asset allocation for the long term which is evaluated infrequently. If you invests according to your own vision, you have to regularly revise or reconsider you vision: is really happening what I had in mind?