When you choose investments, you can’t know how well they will perform. The return you get will depend on a variety of factors, such as the impact of charges, the particular shares or other investments selected, how stock markets in general move, and the asset allocation you choose.
Asset classes and asset allocations explained
An asset class is a broad group of securities or investments that have similar financial characteristics.
Traditionally, there are four main asset classes:
- Fixed-interest securities (also called bonds)
Mixing different asset classes is knows as diversification. It helps you manage the amount of risk you take with your portfolio
Asset allocation is the proportion of your portfolio that you put into each asset class.
At its simplest, an asset class can be defined as a broad type of investment.
One of the most important aspects of risk is the extent to which the value of your investments is likely to swing up and down.
This is called capital risk. Different asset classes have different levels of risk.
For example, cash (saving in things like savings accounts) has low capital risk.
Ranked in order of increasing capital risk, the traditional asset classes generally come out like this:
- Cash (lowest risk)
- Shares (highest risk)
If you want a low-risk portfolio, you should aim to hold a high proportion of your investments as cash and fixed-interest securities.
A higher risk portfolio will have a relatively high proportion in shares.
How much to have in each asset class
In an ideal world, you’d get high returns from your savings and investments with no risk.
Sadly, in the real world, there is a trade-off – to get higher returns, you might have to accept higher risk.
It’s sensible to hold part of your assets in low-risk investments, such as Cash ISAs, and only put some of your assets into higher-risk investments if you’re happy to run the risk of making a loss.
In general, the older you’re the less likely you will want to expose your investments to market risk.
For example, you might be approaching retirement and rely on your investments to generate a regular income.
So you might wish to move out of higher risk investments.
Lower risk assets and diversification of your investments or portfolio will help mitigate these risks.
When investing it is also worth considering the term you wish to invest for as well as your general attitude to risk.
You might also want to consider accessibility to your original investments and allow at least five years for each investment to sufficiently grow.
The above is a general rule of thumb and is only a very rough and ready guide.
Choosing your asset allocation
If you know how much risk you’re prepared to take and how you wish to divide up your investments, you can either:
- Buy investments direct
- Find out about ready-made portfolios designed to spread the risk of your investments
- Use an execution-only broker, who will not give you advice but simply carry out your instructions
Automatic asset allocation
With some investments, you can leave the asset allocation decision to experts.
For example, some investment funds, typically called ‘mixed investment’ aim to hold a specified proportion of the fund in shares.
A ‘mixed investment 0-35% shares’ fund would be a relatively cautious portfolio holding no more than 35% of its investments as shares.
While a ‘mixed investment 40-85% shares’ fund would be much more aggressive with up to 85% of the portfolio in shares.
Another example of automatic asset allocation is where you invest in a pension.
If you do not say how you want your contributions invested, your money will usually automatically go into a default fund.
Generally this will be some sort of ‘lifestyle’ fund, where the proportion invested in shares will be high if you’re young and will automatically shift to the safer asset classes of cash and fixed-interest as your retirement date approaches.
But you should check the details of the default fund to make sure this is the case and that the default choice is appropriate for you.
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