Introduction
Welcome back! In our last lesson, we focused on managing risk within your stock holdings through diversification. You learned that by spreading your investment across 20-30 different companies in various sectors, you can significantly reduce unsystematic (company-specific) risk.
Today, we're taking that principle one step further. We'll move from diversifying within a single asset class to diversifying across different asset classes. This is the core principle of asset allocation: the practice of dividing your investment portfolio among different categories, such as stocks, bonds, and cash.
Many experts argue that asset allocation is the single most important decision an investor makes—even more so than picking individual stocks. By the end of this lesson, you will be able to explain the principle of asset allocation and how it serves as your primary tool for managing your portfolio's overall risk.
1. From Diversification to Asset Allocation
While diversification within stocks helps protect you from a single company failing, what happens if the entire stock market goes down? This is where asset allocation comes in.
Asset allocation involves deciding what percentage of your total investment capital goes into broad categories, or asset classes. The most common asset classes are:
- Stocks (Equities): Represent ownership in a company. They offer the highest potential for long-term growth but also come with the highest risk and volatility.
- Bonds (Fixed Income): Essentially loans you make to a government or corporation. They are generally less risky than stocks and provide more stable, predictable returns.
- Cash and Cash Equivalents: Includes savings accounts, fixed deposits, and treasury bills. They are the safest investments but offer the lowest returns, sometimes not even keeping up with inflation.
The fundamental idea behind asset allocation is that these different asset classes do not always move in the same direction.
Beginners' Guide to Asset Allocation, Diversification, and Rebalancing
To start, let's read a concise guide from Investor.gov that explains why asset allocation is so important for managing risk.
Please read the section titled 'Why Asset Allocation Is So Important.' It directly explains how combining asset classes with different performance characteristics can protect your portfolio.
As the article explains, market conditions that cause one asset class to do well often cause another to perform poorly or averagely. This lack of perfect correlation is the key to managing risk.
2. Asset Performance in the Sri Lankan Context
This principle isn't just a theory; we can see it clearly in the performance of different asset classes right here in Sri Lanka.
Take a look at the following chart. It tracks the growth of LKR 100 invested in different Sri Lankan asset classes from 2015 to 2023.
Look closely at the chart:
- The blue line (Equities) shows high volatility, with sharp peaks and deep troughs.
- The green line (Local Bonds) shows a much smoother, more stable path.
- The orange line (US$/LKR) shows a dramatic increase, especially after 2021, performing very differently from local stocks and bonds during that period.
If your portfolio was 100% in equities, your journey would have been a rollercoaster. However, if your portfolio also included bonds and had some exposure to foreign currency, the downturns in the stock market would have been cushioned by the steadier performance of your other assets. This is the power of asset allocation in action.
3. The Role of Correlation and Risk Tolerance
The goal of asset allocation is to combine assets that have low or, ideally, negative correlation. This means that when one asset's value goes down, the other's tends to stay stable or go up.
To understand this crucial relationship, particularly between stocks and bonds, please watch the following video. It explains why we need different asset classes and how they can balance each other out.
Asset Allocation | What You Need To Know
This video from 'Tae Kim - Financial Tortoise' clearly explains the 'why' behind asset allocation and the relationship between different asset classes.
Please watch from the beginning to 04:42. The video covers: The difference between diversification and asset allocation (00:25). Why different asset classes are needed due to different risk/return profiles (01:48). How bonds can act as a counterweight to stocks, and how your age and risk tolerance influence your allocation (03:37).
As the video highlights, your personal asset allocation depends heavily on two factors we've discussed before:
- Your Time Horizon: If you are young and investing for retirement (a long time horizon), you can afford to take more risk. Your portfolio might be heavily weighted towards stocks (e.g., 80% stocks, 20% bonds) to maximize growth.
- Your Risk Tolerance: If you are a conservative investor who cannot stomach large portfolio drops, you might prefer a more balanced mix (e.g., 50% stocks, 50% bonds), even if it means lower potential returns.
4. The Magic of Rebalancing
Once you've set your target asset allocation (e.g., 60% stocks, 40% bonds), your work isn't done. Over time, as markets move, these percentages will drift. If stocks have a great year, they might grow to represent 70% of your portfolio, making you over-exposed to stock market risk.
Rebalancing is the process of periodically buying or selling assets to get your portfolio back to its original target allocation. This forces you to follow the classic investment wisdom: "buy low and sell high." In our example, you would sell some of the stocks (selling high) and use the money to buy more bonds (buying low).
The following short clip provides an excellent illustration of how rebalancing can actually increase your returns while reducing risk.
Asset Allocation Explained [Modern Portfolio Theory]
This clip from Nick Doyle demonstrates the counterintuitive but powerful benefit of rebalancing your portfolio.
Watch the section from 04:38 to 06:23. It uses a simple hypothetical example to show how selling the winner and buying the loser can lead to better overall results.
Rebalancing instills discipline and prevents your portfolio's risk level from changing unintentionally over time.
Conclusion
In today's lesson, we expanded on the idea of diversification to understand the principle of asset allocation. This is a cornerstone of building a resilient investment portfolio.
Key Takeaways:
- Asset allocation is the strategy of dividing your investments among different asset classes, primarily stocks, bonds, and cash.
- Its main purpose is to manage overall portfolio risk. Since different asset classes perform differently in various market conditions (i.e., they have low correlation), losses in one area can be offset by gains in another.
- The ideal asset allocation for you depends on your personal time horizon and risk tolerance.
- A landmark study found that over 90% of a portfolio's long-term return is determined by its asset allocation, not by the selection of individual investments. This makes it a critical decision for any investor.
- Rebalancing is the disciplined process of maintaining your target asset allocation over time.
Preview of the Next Lesson:
Now that you understand diversification and asset allocation, we'll start exploring different investment philosophies. In the next lesson, we will distinguish between active investing (like stock picking and trying to time the market) and passive investing (like buying and holding a broad market index). This will help you decide what kind of investor you want to be.