Asset allocation is based on the fact that in different years a different asset class is the best-performing one. It is difficult to predict which asset class will perform best in a given year. Therefore, although it is psychologically appealing to try to predict the “best” asset class, it can be quite risky if you get it wrong. Someone who “jumps” from one investment to another, according to whim, may easily end up with worse results than does someone following a consistent plan.
Diversification, which is allocating investment dollars between different asset classes that offer returns that are not perfectly correlated, generally reduces the overall risk in the portfolio in terms of variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor’s wishes in terms of amount of risk and possible returns.
To determine the most applicable asset allocation of your investment dollars requires an understanding of the following:
The above list is not exhaustive. Each of the above assets can usually be purchased directly or indirectly via managed funds or unit trusts.
The next step is to choose the most appropriate asset allocation and investment strategy for each of your goals. For example:
Once you have determined your asset allocation, you then need to:
Re-balancing your portfolio generally means selling some of the assets/investments that have performed well over the year (i.e. take some of your profits) and re-invest those funds into the assets that have not performed as well. However, you will need to take into account any capital gains tax that may apply before deciding to sell any investments.
Although this approach may sound counter intuitive, research has shown that no one asset class has performed the best year in and year out.
Alternatively, if you don’t want to sell any investments and you are adding more funds over the year eg: superannuation contributions or savings plan, you could then re-direct those contributions to the lower-value assets. This will help re-balance the portfolio over time.