What is asset allocation?

Asset allocation is foundational to building diversified portfolios.

The term ‘asset allocation’ refers to the mix of various asset classes in an investment portfolio. The available asset classes typically include stocks, bonds, alternatives, and cash equivalents, with each having a long-term target percentage or range in the portfolio.

To identify a suitable asset allocation, an extensive process is normally followed that firstly evaluates the long-term capital market expectations (CMEs) for all relevant asset classes. The CMEs are then used to produce an asset mix that maximises returns and manages risk, while being aware of various factors like investment goals, client needs, risk tolerance, and importantly, the investment time horizon.

Basic example of asset allocation

As an example, let’s consider the widely used ‘60/40’ portfolio (60% growth assets and 40% income assets).

A hypothetical investor can have a diversified portfolio consisting of 55% stocks, 5% growth alternatives, 30% bonds, and 10% cash equivalents.

This allocation strategy achieves a balance between:

• the capital appreciation offered by stocks and alternatives,
• the income generation and stability of bonds, and
• the liquidity of cash and cash equivalents.

By further spreading investments across different asset classes, sectors and regions, the investor achieves two things: firstly, they reduce the overall risk exposure to any particular asset type, and secondly they lower the overall portfolio’s volatility by combining assets that generally do not move in the same direction at the same time.

The two asset allocation methods used at Craigs

Strategic asset allocation (SAA)

This approach involves setting long-term target allocations for various asset classes. Craigs has a dedicated asset allocation team that works with the Investment Committee to revise the strategic asset allocation settings.

We advise that portfolios are periodically rebalanced back to the target weights to maintain the desired allocation mix.

Tactical asset allocation (TAA)

The Craigs Investment Committee offers tactical asset allocation advice, which involves making shorter-term adjustments (typically with a 6-to-12-month view) around the SAA based on market conditions and economic forecasts.

An example is to purposefully take an overweight position of +3% to international equities and a -3% underweight position to global bonds, or vice versa when you expect bonds to outperform equities on a risk-adjusted bases.

The significance of asset allocation

Various studies have shown that the asset allocation decision is the most influential decision that can be taken when trying to achieve long-term goals.

You can be the best stock-picker or fund-selector in the world, but if you do not have the correct exposures to the broader asset classes you may miss the mark at retirement or when you need to use that lump sum.

Over both the shorter and longer terms, the asset allocation mix enables investors to benefit from the varying performance cycles of different asset classes. When one asset class is underperforming, another may be delivering better results, offsetting the losses and stabilising overall portfolio returns.

An appropriate asset allocation that ultimately balances diversification, risk, reward, investment objectives and various other constraints, and is foundational to achieving the long-term goals from your tailored portfolios. Regular rebalancing, alongside the occasional tactical tilt, should enable clients to achieve all their desired outcomes.

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