September 21, 2006
How To Choose The Right ISA - Asset Allocation
As mentioned in an earlier post, an ISA is not actually an investment. It is a tax wrapper that allows your investment to grow tax efficiently.
It’s therefore crucial to understand where you’re investing your money.
There are four common areas in which you can invest your money:
• Cash
• Bonds
• Property
• Equities (shares)
Where you choose to invest will depend upon a number of factors, such as the length of the investment, your attitude to risk, your current level of investment knowledge and your confidence in your decisions.
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among the major categories (as above). Each asset class has different levels of return and risk, so each is likely to behave quite differently over time.
For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a settlement for mediocrity, but for most investors it's the best protection against major loss should one investment class underperform.
The consensus is that asset allocation is one of the most important decisions that investors make.
In other words your selection of actual shares or bonds is secondary to the way you allocate your assets to high and low-risk shares, to short and long-term bonds, and to cash and property.
The aim of asset allocation is to reduce risk by diversifying the portfolio. For example, if all of a portfolio's assets are concentrated in one area, such as shares, it’s likely to be more risky than a portfolio whose assets are spread out among diverse investment categories.
An asset allocation appropriate to your goals and time horizon provides the best chance that you will meet your financial goals. In addition, you should examine your overall financial resources and personal ability to tolerate risk when making asset allocation decisions.
The Problem
Many investors are either unaware of asset allocation, or have heard of it but may be put off understanding it fully as it does take some time to appreciate the benefits that it can bring.
Alternatively, they may be using the services of a financial adviser that does not use the process of asset allocation. We believe asset allocation is crucial. When we meet prospective clients, many have never heard of it and their existing portfolios do not show evidence that it is being used.
Diversification
Most investors are concerned about the risks associated with financial markets; namely, that their investments will lose money or will not grow enough over time to outpace inflation. Diversification is an important strategy used by investors to help reduce this risk.
Because the markets for shares, bonds, property and cash do not all move in the same direction or to the same degree, an investor's portfolio that combines these asset classes should be less risky than one that includes only one type of investment.
A diversified portfolio has historically produced better returns than one that has concentrated in more conservative asset classes, such as short-term bonds or cash. A diversified portfolio is also less likely to experience stomach-churning volatility than one concentrated in the most aggressive investments.
Over time, of course, long-term goals such as retirement or funding your child's education will become medium and short-term goals. As your time horizon shifts, your asset allocation may need to alter accordingly.
Typically, investments offering the greatest growth potential also pose the greatest risk. An investor with a short time horizon might want to minimise or avoid higher risk investments such as shares or investment funds because the growth potential offered by these investments over time can be offset by short-term volatility (risk).
If your time horizon is sufficiently short, say three to five years, you may wish to concentrate on more stable investments such as bond funds, or even cash accounts. While bond funds offer no guaranteed rate of return, they are generally less volatile than shares and usually offer greater returns than cash.
Those with a longer time horizon can generally afford to invest more aggressively because short-term volatility will usually be overcome by long-term growth. For long-term investors, the growth potential offered by shares tends to offset the effects of inflation.
Action Point
So what can you do to make sure your investment strategy has the right asset allocation?
A starting point is to follow these simple steps:
In a few days we'll look at how to choose the right investment funds.
Filed under Investing by Ray Prince
