Portfolio Construction Starts With Asset Allocation: An Intro to Calculate Yours

Introduction

The first thing to do when starting your investing journey is to plan what a suitable portfolio might look like for you. There are a number of factors to consider but the main one is to do with risk. Risk and return are strongly correlated, naturally: the higher risk of volatility you are willing to bear, the more likely you are to make outsized returns, and vice versa. Investors with a long-time horizon and larger sums may feel comfortable with high-risk, high-return options when creating their optimal portfolio. Conversely, if you only invest in ultra-safe defensive investments, you will have to accept the likelihood that these will return minimal capital, as safer investments have lower return potential. However, by prudent mixing, investors can provide stability and growth potential to their portfolio.

So what’s the upshot of this? Well, it means that the allocation of your portfolio is largely determined by two factors: your ability and willingness to bear risk. The former is dictated by your financial situation: what is your time horizon? Do you have a family / dependents who rely on you? Do you have a stable income? Do you have a mortgage to pay? What will this money be needed for? For example, if you’re hoping to use the proceeds for a house purchase in the next year or two, investing in the stock market, where multi-year downturns are not out of the norm, is probably not wise. The latter is a more personal question: how comfortable are you with investment risk? Would you be kept up at night by 20-40% fluctuations in the values of your holdings? The answers to these questions will dictate what exactly you invest your money in.

What is asset allocation and why is it important

Asset allocation involves dividing your investments among different assets, such as stocks, bonds or cash. It is important to note that as perhaps insinuated, there is no magic formula: this is an idiosyncratic decision based on personal circumstances, including one's investment objectives which outline risk tolerance, return requirements, and any constraints that might affect the portfolio. It is also not static: your target allocation will change over the course of your life as both your willingness and ability to bear risk change. Understanding the investment process is crucial in guiding these asset allocation decisions to meet specific financial goals.

Furthermore, asset values are not static. As your holdings grow (or shrink!) in size, their relative size compared to the rest of your portfolio will naturally change. It is therefore vitally important to keep a target allocation in mind, and periodically rebalance towards this, to make sure that your portfolio reflects your risk profile at all times. Of course, short term fluctuations and periods of market volatility will throw this out of whack now and again, so you have to learn to recognise when it’s having a wobble and when there are structural problems that should be addressed.

How to calculate your asset allocation

Firstly, the basic premise of diversification dictates that you can reduce portfolio risk without compromising performance by spreading your capital across asset classes. Or more succinctly: “Don’t put all your eggs in one basket.” Understanding your investment horizon is crucial in this process as it influences how you allocate your capital across different asset classes like stocks, bonds, cash, crypto, property, etc., based on your long-term financial goals and risk tolerance. An investor with a longer investment horizon may lean more towards stocks for potential growth, while those with shorter horizons might prefer bonds or cash for stability. You can diversify across asset classes, but also across countries, and within each individual asset class. For example, a portfolio that is well split between stocks, cash, bonds, crypto, and property may appear well diversified, but if all of the stocks are Taiwanese microchip manufacturers, for example, then you aren’t really diversified at all.

Of course, the easiest way to diversify is by owning funds. Furthermore, by diversifying among funds you are able to quickly and easily spread your capital around a whole load of different countries, industries, and sectors without knowing full details of each company. There exist funds with broad and narrow focuses, and understanding your investment horizon helps in selecting the right mix, enhancing your portfolio's ability to meet your financial objectives over time. You’ll have to do a little research before deciding which to invest in. Bear in mind that past performance is not an indicator of how a fund might do in future, and you will have to weigh up a number of factors before making a choice. We particularly like the Hargreaves Lansdown Wealth Shortlist: their analysts provide detailed research on a number of funds which makes it easier to choose.

Tips for constructing an effective portfolio

Although we can't tell you exactly how to choose, there are a number of base scenarios which you can use as a starting point. Our weekly investor profiles published on social media also give you an insight as to how some of the most renowned investors on the planet choose to allocate their funds. We also particularly like the Vanguard asset allocation questionnaire which incorporates time horizon and risk tolerance.

So, onto the good stuff. Firstly, it's important to know where different investments fall on the risk/return profile. The pyramid below shows where the main ones fall, and give you an indicator as to what sort of things people hold in their portfolios. For example, alternatives like cryptocurrency tend to be more risky than stocks, which tend to be more risky than bonds, which tend to be more risky than cash or equivalents.

The baseline "no-brainer" portfolio is a 75-25 equity bond split, and this is a good starting point to gauge in which direction to head first, although the 60-40 split is perhaps better known.

From here, we can surmise that younger investors generally should have more exposure to risk, given that they have a much longer time horizon over which to bear volatility. "Age in Bonds" is one historical way in which people have calculated their stock-bond split, although a slightly more aggressive "Age minus 20 in Bonds" is also common. It is generally accepted that you should be predominantly invested in stocks when you have more than 5 years to go until you need the capital. Although the trend recently has been to push for alternative investing in things like cryptocurrency, venture capital, private equity and P2P lending. These should generally not comprise more than 10% of a standard portfolio, all being equal, unless you have access to more detailed information or tax benefits that might weight these in your favour. Being the most volatile, these are also the most subject to wild swings in value, and will hence probably need to be rebalanced more often.

Rebalancing

There are 3 ways in which you can rebalance your portfolio back towards your target allocation:

1. Sell investments that are overweighted
2. Buy investments that are underweighted
3. Alter your regular contributions to push your trajectory back towards your target allocation

Final thoughts on the portfolio construction process

One of the very first features we decided to include on the Strabo platform was an asset allocation breakdown, along with suggestions and direct tools to be able to perform your regular rebalance. Whichever model you decided to use to determine your allocations, it should be consistent with your personal risk profile and monitored on a regular basis as your personal circumstances change. You can sign up for further updates on this or to use the platform directly at the link at the foot of the page, which will also provide you more detailed portfolio analytics for a deeper dive.

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