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What Is Asset Allocation?

moneyAsset allocation is the mixing of asset classes within a portfolio to deliver a particular return for a given amount of risk.

We all know for instance that, in general, shares can be more volatile than bonds, and that bonds can be more volatile than cash. So, asset allocation attempts to mix those assets in a scientific way that will achieve an appropriate expected return for an investor.

It should be said that there is no unique formula that can determine the right allocation for every individual. However, the Rule of 100 can be used as a convenient starting point. Quite simply, the Rule of 100 states that the proportion of cash (and near cash investments) in your portfolio should be equivalent to your age in years. The rest should be in shares.

So, someone who is aged 20 should ideally have 20% of his or her portfolio in cash and 80% in shares. But as the investor gets older, the proportion of cash in the portfolio should gradually rise too. So by the time the investor reaches 80, he or she should have 80% in cash and 20% in shares.

A portfolio comprising 80% cash and 20% shares could theoretically deliver a lower return than on that which is made up of 20% cash and 80% shares. If we assume that cash has returned around 2% over the long term, while shares have returned 10% then it is possible to work out the blended return for the two portfolios. The shares-heavy portfolio should deliver a return of around 8.4% while the cash-heavy portfolio should return 3.6%.

So armed with a theoretical expected return for the portfolio and a given investment target, an investor can determine how much and for how long he or she needs to invest given the level of “risk” that will be assumed

It is important to remember that asset allocation is not about second guessing what the market may or may not do. Instead it is about imposing strict disciplines on managing the portfolio. This may mean periodically re-balancing the portfolio by selling winners and buying losers.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.