We know already that asset allocation is the most important investment decision you will make. So how to decide what percentage of your money should be allocated to which assets? One factor is your stage in life: Young people have time on their side and are looking to grow their money over that time. Someone nearing retirement may no longer be looking for capital growth – they are going to need income from their investments and a significant drop in value would be damaging.
Another thing to consider is your risk tolerance. This can vary wildly from one person to another, even within your family, and it’s important to understand what level of risk you are able to bear.
The first part is to determine your investor experience. This can be summed up fairly simply:
Inexperienced Investor: You have invested in a limited range of asset classes for a period of less than four years and/or your investment knowledge is low or poor. However, you do understand that prices of securities may go up as well as down.
Experienced Investor: You have invested in various asset classes for a period of more than four years and have experienced volatility. Your investment knowledge is good and you acknowledge investment risk.
Professional Investor: You frequently trade various asset classes and have done so for more than four years. As an individual you have in excess of US$1.1 million of ‘investible’ assets and have extensive investment knowledge.
So what really separates an experienced investor from an inexperienced investor? The key term here is that you have “experienced volatility”. Simply put, if you have invested in a variety of assets for four years or more then you will have lost money somewhere!
The next part is to determine your risk tolerance. If you search online you will find numerous risk profiling questionnaires. Try one or two and see what results you get. For reference, here is a typical one from HSBC, and here is a more fun one from Rutgers.
Typically risk profiles are divided into two major categories:
- Strategic – for long term planning,
- Tactical – either aggressive trading, or focussed on a specific life stage such as pre-retirement, post retirement, or income generating
We won’t get into the tactical profiles today, suffice to say that needs can change with major life events. If you are retired then long term capital growth is less of a concern and your focus is likely to be on capital preservation and generating income.
- Conservative – investors primarily interested in income and modest growth potential. The allocation is relatively defensive but has a modest exposure to growth assets. Looking for income and capital growth from investments.
- Balanced – investors with some time until retirement. The allocation invests in
a much broader range of assets than a typical balanced fund, which will result in lower potential for capital loss whilst at the same time offering growth potential. Looking for income and growth from investments, but more focussed on growth.
- Growth – investors who have a longer investment time horizon, primarily interested in capital growth, and are comfortable with modest short-term capital losses. The allocation is biased towards growth assets, but still invests in a broader range of assets than a typical growth fund.
- Alpha – investors who wish to adopt an aggressive approach, with the sole aim of long-term capital growth. Medium-term losses should be expected. The allocation is almost entirely biased towards equities and other growth assets.
The names and definitions of the strategic profiles may differ depending on who you ask. Alpha may be called adventurous, for example. The important thing is to start to understand where you fit in on the risk scale so you can plan your asset allocation accordingly.