We’ve all heard the phrase, “Don’t put all your eggs in one basket!” This old maxim perfectly describes the concept of asset allocation. If you put all your savings in one type of investment and the investment fails, you could jeopardize your savings. Asset Allocation refers to how you spread your money among a number of different asset classes such as cash, bonds, stocks and real estate. This strategy looks at your particular goals and circumstances and determines the most appropriate asset mix for you within the various asset classes.

 The main purpose of this strategy is to reduce investment risk. History has shown that in general, various types of investments perform differently. Whilst money-market returns tend to offer low returns, your initial investment is relatively safe. Bonds may not be as lucrative, but offer more stability than stocks; they offer a middle ground between cash and stocks in terms of risk and return. Stocks, on the other hand, offer the highest return among these three classes, but they also carry the highest risk.

 How much should you put where?

 As you pass through your life cycle, your financial goals will change. Each investor’s approach to asset allocation will differ and depend largely upon their age, life stage, financial goals and risk tolerance. Generally, the younger you are, the more risk you can afford to take. A 22-year old just starting out in the workforce will have a completely different view of risk from a 55-year old approaching retirement. The closer you are to retirement the more important the preservation of the wealth that you have worked so hard to accumulate becomes.

 Some general rules

 General rules for asset allocation suggest that any money you need next year should be in cash, money you need in two to three years in fixed-income investments, and money you can afford to put away for four to five years and beyond can be invested in the stock market. This ensures that the cash you need today is readily available, the money you will need in a few years’ time will be safe from stock market volatility, and money you can afford to put away for several years is invested in the stock market.

Diversification

In many ways asset allocation is synonymous with diversification.  In addition to diversifying across asset classes or even geographically, you should also be diversified within each asset class. For example, when it comes to investing in stocks, instead of investing all your money in just one or two companies you may choose to invest in different sectors including banking, manufacturing or insurance. This helps you diversify your investment risk as any losses caused by the downturn in one sector may be offset by a rise in another; it is unlikely that all sectors will perform in exactly the same way and decline at the same time unless there is a general reversal of the entire market. Asset managers generally seek to ensure that no single asset represents more than say five to ten percent of your total portfolio.

Diversify according to your goals

Based on your various goals, you require different levels of liquidity.  For your short-term goals such as the funding of a family holiday or a family wedding this year or next, you will require cash to make payments. For the longer-term goals such as the funding of your children’s education or your retirement, your investments in the stock market or real estate will offer you better prospects for long-term growth.

Bear in mind that asset allocation does not assure you of profit nor does it protect you from losses in a declining market. It is important to review your asset allocation strategy periodically and adjust your portfolio as your circumstances and objectives change. This will ensure that the portfolio remains reflective of your long-term needs and outlook, whilst also addressing your short and medium term goals. 

 The full text appears in “A-Z of Personal Finance” by Nimi Akinkugbe. Available in leading bookstores including Glendora Books, Laterna Books, Patabah, Terra Kulture, Quintessence, Jazzhole …and online from Jumia, Amazon, Barnes & Noble, Manna Books and AMV Publishing.