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Your first step to a first-class investment strategy
Asset allocation – the decision over how much to invest in equities, bonds, property or cash – is crucial. Mike Deverell of Equilibrium Asset Management provides a helping hand.
The cornerstone of any investment strategy is the asset allocation.
The decision over how much to invest in equities, bonds, property or cash is crucial. Academics tell us this decision makes up around 90% of the variance of your returns.
However, making asset allocation decisions is not easy.
Unless you are an investment genius or extremely lucky, you should diversify your portfolio across multiple asset classes.
The first determinant of asset allocation is risk. How much risk can you tolerate emotionally? How much risk can you afford to take? What return do you need to achieve your goals?
Before investing, decide how much you need to keep in cash to cover emergencies, perhaps three months income or 10% of your portfolio. If you need access to cash within the next two years, it is unlikely to be a good idea to invest it.
You should also keep a substantial chunk of your portfolio in low to medium risk assets like property and fixed interest, especially if you are taking income. A good rule of thumb is 10 years income, so if you are taking 5% out of your portfolio a year, keep 50% in low to medium risk assets.
Once these criteria are satisfied, you can then invest the balance in equities. As a rule of thumb, keep equity investment below 75% even if you have a very high risk tolerance. This allows you to rebalance when markets fall, topping up holdings to benefit from a recovery.
Strategic vs Tactical asset allocation
The above process is a good way to work out your strategic asset allocation. This is where you would invest long term if you had no opinions on the market and were happy to leave your portfolio for 10 years without management.
However, most people prefer to actively manage their asset allocation, adapting it to market conditions. This is known as 'tactical' asset allocation.
To determine your tactical asset mix you should consider the relative value of each asset class. The premium above cash or gilts, for example, is one way of deciding if the asset class looks cheap or expensive.
Here are some basic ways of looking at the major asset classes. Note that we are ignoring property in this article because data is not easily available to the non-professional investor. At Equilibrium, we are not currently holding property in our portfolios.
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