Asset Allocation

Asset Allocation is the process by which the total investble capital is distributed across different asset classes. As discussed in the previous article, asset classes are sets of assets that behave similarly and have similar characteristics, e.g. Stocks, Fixed Income Securities, Commodities and Cash (Cash Equivalents).

Investors typically do not invest all their money in one asset class or one single security. The reasons for this will become obvious as we continue through this article. Asset allocation depends heavily on the individual needs of investors, their risk profiles and unique constraints. Young investors with a high disposable income tend to invest heavily in stocks while middle aged investors tend to invest in balanced portfolios consisting of both stocks and fixed income securities. Retirees tend to invest heavily in high grade debt securities (bonds etc).

As discussed in the previous article, tax structures influence asset allocation. Equities are preferred in countries with high tax rates as taxes typically apply only to dividend income and realized capital gains. The tax drag can be minimized by deferring the realization of capital gains. We will discuss different tax structures and tax drag in a separate article.

A study found that up to 90% of the return of portfolios can be explained simply by asset allocation (as opposed to market timing or other factors). Thus, in my opinion, asset allocation is the single most important part of portfolio management.

Diversification
Diversification is the process of reducing the overall risk of the portfolio by investing in several securities (typically across different asset classes) instead of investing in a single security.

Benefits of diversification The main benefit over diversification is the reduction of risk (volatility of returns).As we discussed in the previous article; risk is the volatility of returns. Every fund manager would like to have the highest possible return with the lowest possible risk.

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