Once I identified my goals and purpose for investing, I set about creating an investment plan that met my needs. One of the first things I did was to determine an asset allocation for my portfolio. I was able to do so by answering two simple questions:
#1: What is my risk profile?
Our risk profile is fundamental to how we construct our portfolio and telling of how we will manage our expectations in the face of market volatility. People who are risk-averse may be inclined to allocate a larger portion of their portfolio to low risk products (eg. endowment plans, fixed deposits, bonds) while those who are more aggressive might choose riskier ones (eg. stocks, forex, options).
Everyone has different thresholds for stomaching risk and it is better to be honest with yourself and learn this sooner than later to manage your expectations on your investment journey.
That being said, our risk appetite can change in different phases of our life which leads me to the next point: investment horizon.
#2: What is my investment horizon?
Investment horizon refers to the duration we expect to hold onto any investment. It would likely depend on our age, priorities, and existing circumstances.
The longer the time horizon, the less the variability in average annual returns. Investors should not underestimate their time horizons.John Bogle in Common Sense on Mutual Funds
Generally, investors with longer investment horizons will be able to ride out different market conditions and therefore take on higher risk investment vehicles in exchange for potentially higher returns. Whereas investors with shorter investment horizons might consider less volatile and more liquid investment vehicles to withstand short-term adversity.
As a young investor, time is my greatest asset (ha ha). I had no immediate need for a large sum of money which is why I started with a rather aggressive portfolio.
Understanding my risk profile and investment horizon helped me to determine a suitable asset allocation
An often cited rule for determining portfolio allocation is to subtract your age from 100. The number you get is the percentage to hold your portfolio is stocks and the rest would be the percentage of bonds. The idea is that as we age, our risk tolerance decreases and we would prefer to hold an increasing portion in safer alternatives.
However, I’d like to think of this as more of a guide than a hard-and-fast rule. I know 25 year olds who like to hoard cash and absolutely shun from the stock market.
Select a sensible portfolio and allocate your capital in a way that lets you sleep at ease at night. You can gradually tweak it when you gain more confidence.
Is asset allocation necessary?
Asset allocation helps to protect your portfolio against volatility by balancing risk and reward. This is possible by diversification across different asset classes, of which each comes with its own characteristics and behaviour under different market conditions.
Therefore, whether you are just beginning to invest or already years into it, it is worth looking at your portfolio’s asset allocation to ensure that you are effectively maximising returns and minimising risk.
Now that we have determined our ideal asset allocation, it is time to explore the types of asset classes and choose our investments! Find out what I did for my portfolio in the next post.