Johannesburg – When investing, you do so with the intention of achieving your required investment outcomes.
While there are several factors that can contribute to, or detract from performance, the underlying asset allocation of your investments is the large lever impacting both the risk and returns of any portfolio.
Asset allocation as an investment strategy is based on empirical studies focused on how each asset class performs and correlates relative to each other.
Let’s look at the asset classes typically used for investments, what asset allocation means and the process employed.
Asset classes explained Broadly speaking, there are four main traditional asset classes. These are cash, bonds, property and equity. Each asset class has different levels of risk and reward, investment time horizon and protection against inflation, which are explained as follows:
• Cash – investments linked to interest-bearing bank instruments such as call accounts or money market funds. This asset class is lower risk, and works best for short-term goals (typically one year or less). The performance of this asset class is directly linked to interest rates.
• Bonds – interest-bearing loans issued by government or corporates. This asset class is a low- to medium-risk category with medium- to long-term investment time horizon (five to 10 years). The risk associated is linked to the issuer being able to pay returns, prevailing interest rates potentially being higher than the rate of return of the bond, and inflation reducing the real interest that an investor may receive.
• Property – linked to listed property companies and property investment companies. This asset class is a medium- to highrisk category, with a mediumto long-term investment time horizon (five to 10 years). These investments are generally adversely affected by interest rate increases and are impacted by the macroeconomic environment of the country.
• Equity – the high-risk, high-reward asset class. Investors own a share in the listed company they are invested in. You are directly impacted when there are profits or losses in a company and you are also subject to stock market movements.
Equity is considered a long-term investment (seven to 10 years or more), due to its volatile nature. Your capital may not be guaranteed, but there is no ceiling on the returns. As an asset class, equity has generally produced higher returns for investors over the long run, however, this asset class can be volatile.
What is asset allocation?
Asset allocation is the process of dividing an investment portfolio between different types of asset classes such as stocks, bonds and cash as well as choosing the right mix of asset classes while constructing the portfolio with the intention to minimise investment risks and maximise growth potential or enhance returns.
There are two common approaches to asset allocation, strategic and tactical asset allocation. Strategic asset allocation (SAA) is the long-term focus of the fund and is considered the most likely approach to achieve the fund objective.
Tactical asset allocation (TAA) uses techniques to improve risk-adjusted portfolio returns by taking advantage of short-term opportunities and aims to maximise short-term investment strategies.
Over the long-term, a portfolio’s SAA will be the main contributor to achieving its return and risk objectives.
These returns can, however, be enhanced through short-term TAA, where we seek to take advantage of temporary mispricing across asset classes.
By Anil Thakersee
• Thakersee is executive for marketing and business development at PPS Investments.
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