Asset allocation: mixing and matching investments to meet your goals

IF you do not have much money to invest, it may seem like a good idea to put all you have in a single stock or sector that you have thoroughly researched.

You may even have read of investors who went all-in on speculative counters with "diamond hands", and then saw their stocks rocket "to the moon".

But putting all your eggs in a single basket means your capital would be wiped out in an adverse event. Unforeseen occurrences such as fraud, corporate actions, or even a pandemic can be detrimental to specific companies or asset classes.

Conventional investing wisdom suggests that diversifying and spreading your capital across asset classes is a more prudent and sustainable approach to managing your wealth and growing your portfolio.

This brings us to the topic of asset allocation, which is essentially how you would spread your capital across different asset classes.

What are asset classes?

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An asset class is a group of investments with similar characteristics. Each asset class has a distinct risk and return profile, and investors can use this profile to make strategic allocations based on their priorities.

Common asset classes include:

• Stocks - also known as equities - which represent an ownership stake in a company;
• Bonds - also called fixed income - which are loans to companies or countries that pay you interest over time and;
• Cash and equivalents

Each asset class can be further divided by sub-categories, for instance by company size (large, mid or small-cap), geography (developed markets or emerging markets), and quality (investment grade or high-yield) for example.

In investing, risk and returns are closely linked. Investing in riskier assets would demand a higher potential return as compensation for the potential capital loss.

Stocks are riskier investments because their share prices tend to move up or down more than bonds. But that also means there is greater potential for capital appreciation.

Looking into the sub-categories, we can also see that large companies in traditional sectors such as banking or real estate tend to be less volatile than smaller companies in growth sectors such as technology.

Bonds, meanwhile, can be rated according to the credit worthiness of the issuing company. Higher quality instruments - what we call investment grade - with low probability of default would pay lower interest than riskier high-yield bonds issued by the more heavily indebted companies.

Beyond stocks and bonds, there are also alternative assets. These include real estate, gold, commodities and even private equity.

These alternative assets may generate good returns but they are less liquid. This means that if you need to convert them into cash it may be more difficult to do so quickly or you may lose some of your initial investment if forced to liquidate at an inopportune time.

Allocating your capital across different asset classes or sub-categories is important not only to ensure that your money is spread out across multiple investments, but also because the various asset classes tend to exhibit less correlation with one another.

Bonds, for instance, have tended to move in the opposite direction from stocks. This means that factors affecting one asset class may leave your other portfolio components less adversely affected, and can protect against a drastic loss.

How to deploy your capital?

There are many different approaches when it comes to asset allocation, but most of it would depend on your investment goals, risk tolerance and time horizon. You want to allocate your assets to achieve your objective.

For many millennials, FIRE (financial independence, retire early) is a trending goal. Other common investment objectives can be funding university education for a child or accumulating enough capital to bequeath to your dependents.

If you are looking to invest for retirement, your current age can be something to consider when deciding how you allocate your assets. One formula that can be used is subtracting your age from 120 to determine the percentage allocation for equities.

Using such a strategy, a 25-year-old investor would theoretically allocate 95 per cent of his capital to equities. This can make sense, as a young person would have limited financial capital but plenty of human capital (the ability to earn and save money over time).

A larger allocation to equities provides opportunity for greater capital appreciation over a long period. Younger investors are generally less dependent on cash flow coming from investments as they would still be employed, and with a longer investment time horizon they are able to ride out any fluctuations or downturns.

On the other hand, an older investor would have different priorities.

Using the same formula, a 60-year-old investor would allocate just 60 per cent of his capital to equities with the remainder in bonds.

For the senior investor close to retirement, cash returns from an investment portfolio may be essential. This can make capital preservation and a steady cash flow a greater priority than capital appreciation.

For such investors, a tilt to fixed income instruments would be appropriate, as bonds pay out steady returns through their coupons. The principal sum is also returned to the investor (assuming that there is no default), and can assure an older investor that his retirement needs are secured.

The above is just a theoretical example, but similarities can also be seen in real life target date retirement funds. These are funds that automatically adjust their allocation to tilt towards bonds as the years go by.

Given that equity and bonds are fairly broad in nature, investors would also need to think of the sub-categories they invest in and if the potential risk and returns are in line with their profile. This can also tie in with fundamental analysis.

For instance, you can carry out a top-down analysis and identify macroeconomic trends to determine sectors or geographies that are likely to outperform. If your analysis, for example, suggests that Asian markets would outperform US markets over the next year, you may then decide to weigh your equity portfolio more heavily in Asian equities and less in US equities.

There are also other ways people may choose to allocate their assets, such as having an equal-weight to each asset class.

It is important to note that there is no single correct way to carry out asset allocation, as there are various factors to consider and many different approaches in the market.

Generally speaking, a larger allocation to riskier assets such as equities makes sense if you have a longer investment time horizon and/or a higher risk tolerance. Conversely, lower-risk instruments such as fixed income may be preferred by those who are risk-averse or have a shorter time period to invest.

Asset allocation is also not a one-off decision, as circumstances change over time. You should regularly review your portfolio, and consider how your asset allocation strategy fits your current needs and make adjustments to it where necessary.

• This is the fourth instalment of Invest & Grow, a weekly 10-part series that aims to help new investors get started on their investment journey.