Parking all your money in one asset class is a recipe for disaster. Instead, experts say a balanced portfolio that spreads your money around will help to protect you from risk.
In these volatile times, asset allocation is a fine art
Parking all your money in one asset class is a recipe for disaster, especially in these volatile times. Instead, experts say a balanced portfolio that spreads your money around will help to protect you from risk.
If you are crazy enough to invest all your money in a single stock or fund, you should brace yourself for a roller-coaster ride.
If you're lucky, your investment will fly skywards and do a celebratory loop-the-loop, but it is just as likely to come crashing down. You are dicing with financial death, which is a foolhardy thing to do.
That's why most people spread their money around. They keep some money in cash for emergencies, then invest the rest in a diversified spread of stocks, bonds, property, gold and other assets.
You couldn't give this process a more obscure name than asset allocation, but that's what it's called.
Asset allocation is an art, not a science. And it's a very personal art. How you spread the money around depends on your personal attitude to risk. If you're a young, aggressive investor with time on your side, you can afford to take greater chances by pumping more of your money into higher-risk stocks and other assets.
If you're older, cautious and close to retirement, you should allocate more of your money to more solid assets such as cash and bonds to spare you from a last-minute market meltdown.
Start by working out how much money you want to invest in each asset class, says Steve Gregory, the managing partner at Holborn Assets, the financial services company in Dubai. "A low-risk investor might want to allocate, say, 50 per cent of bonds, 30 per cent to cash and 20 per cent to stocks and shares. More aggressive investors may wish to invest a lot more in shares to seek larger gains."
That's asset allocation, the simple version. As we're talking investments, it can get a lot more complicated than that.
Asset allocation is the single most important factor driving your portfolio, says Richard Urwin, the managing director at BlackRock, the asset management firm. "It is highly unlikely you will meet your long-term goals by investing in a single stock, fund or property. Diversifying across different sectors can help boost your returns, reduce volatility and avoid disasters."
The skill lies in deciding how much to invest in each asset class. As we've seen, this partly depends on your attitude to risk and partly on the economic cycle.
Stocks and bonds, for example, look attractive at different stages of the cycle, Mr Urwin says. When the global economy is booming, company profits rise and share prices follow. In a downturn, share prices fall and so do inflation and interest rates. This makes bonds, which pay a fixed rate of interest, more attractive. By holding a mix of both shares and bonds, your portfolio is prepared for both boom and bust.
You also need to hold a mix of different kinds of shares and bonds, Mr Urwin says. "Defensive equities, such as solid global blue chips paying attractive dividends, perform relatively well when the global economy is struggling, as we've seen lately, while riskier cyclical growth stocks do better in a boom."
A balanced portfolio might also include a blend of low-risk government bonds and riskier, but potentially more rewarding, high-yield bonds.
The key is to invest in asset classes that have low levels of correlation, which means they perform differently at different stages of the economic cycle. Shares and gold, for example, don't correlate. Stocks fly when the economy is booming, gold often glitters in a bust.
This spares you the agony of trying to time the market or predict which investment sectors will perform next, says Ishtaj Rahman, the head of alternative trading strategies at Barclays. "This is notoriously difficult and most private investors shouldn't even try. Too many people have a habit of chasing previous winners, which is often the wrong strategy."
There are times when investments correlate in the worst possible way by collapsing at the same time. This is what happened at the height of the crisis in 2008, when cash, shares, property, gold and hedge funds all tumbled together.
Asset allocation isn't something you do once, then forget about. You have to return to it regularly, shifting money into different asset classes to make sure your portfolio still matches your attitude to risk.
A good way of rebalancing your portfolio is to recycle the profits from your winners into your losers, says Patrick Connolly, the investment planner at AWD Chase de Vere, the financial services firm. "It sounds counter intuitive, but it can work. Investments move in cycles. Last year's winner is unlikely to be this year's winner. Too many people assume it will and end up buying at the top of the market, which is never a good idea."
Wise investors do the opposite by stocking up on asset classes that have fallen. "The losses have already been made, but not by you. When that sector swings back into fashion, you should reap the benefit, provided you are patient," Mr Connolly says.
Over the past 12 months, US equities have risen 11 per cent, while Chinese stocks have fallen 14 per cent, Mr Connolly says. "If you originally had US$10,000 [Dh36,730] in each, today you would have $11,000 in the US and $8,600 in China. In this case, you could rebalance your portfolio by investing your US profits in Chinese equities."
If you do this consistently, you are effectively selling at the top of the market and buying at the bottom. "And that's the holy grail for every investor," Mr Connolly says.
So where should you be investing now? Andrew Cole, the investment manager at Baring Asset Management, suggests investors should take advantage of recent falls in emerging markets to rebalance their portfolios. "We expect China and the rest of the emerging world to drive global growth and deliver attractive returns to investors over the long term."
A well-balanced portfolio still allows you the freedom to have a bit of investment fun, but with a small proportion of your money, says Mr Gregory. "For some investors, that might mean a single country mutual fund, investing in, say, Indonesia or Taiwan. "
Asset allocation doesn't have to be boring. You can still take that ride on the investment roller coaster, but you have a nice safety net in case you come crashing down.