Why asset allocation is crucial in investments

Before going into the nuts and bolts of asset allocation, I need to fully convey why it’s important to get this right now, before investing to shift risk. One of the most important decisions for your investment portfolio is how you choose to allocate your assets.

Asset allocation refers to the mix of investments you hold. A sound asset allocation strategy ensures your investment portfolio is diversified and aggressive enough to meet your savings goals without unnecessary risk. Examples of asset classes include stocks, bonds, foreign investments, real estate, commodities and alternative assets such as precious metals.

To manage downside risks ignore the impulse of piling all your investments into the latest, popular asset class. I believe you can turn any market into a potentially wealth-building opportunity over the long-term by properly diversifying, cost averaging and rebalancing your account.

When you go to your local soko mjinga, you grab a shopping basket. The basket is like your total investing portfolio; it’s where you place all the items (assets) you’re going to purchase. The point of asset allocation is to broadly diversify your investment portfolio, just like you probably diversify your diet. Think of it this way, even if you love nyama choma, you don’t want to eat them all the time because you’ll miss out on nutrients in other foods. So you fill your cart with a variety of foods.

As you shop, you don’t organise your groceries yet — you just throw it all in there. But you can easily categorise your purchases by food group: Meat into one bag, fruits and veggies in another. Each of these food groups is akin to an asset class in your portfolio. You may hold dozens of different investments and within each of them are real estate, alternative investments, stocks, bonds, and cash. You can’t quickly tell by glancing at your grocery basket how many veggies versus fruits you have, but you can (and likely do) separate it out in your head to know you’re buying food for a balanced diet.

Just as it’s not healthy to eat only nyama choma, in investing it’s not healthy to be overly invested in one asset class. The goal of proper asset allocation is to create an ideal mix of investments that gets you the greatest long-term gains for a tolerable amount of risk. The goal is to get a return on your money while managing risk. Even if you’ve never invested a cent, you’ve heard the adage “Don’t put all your eggs in one basket.” That’s the rationale behind the investing strategy of diversification. Just imagine where you’d be if you had put every investments you had into Uchumi supermarket, Gakuyo real estates, Metropolitan Teachers Sacco, Mumias Sugar or Athi River Mining.

There will, of course, always be market risk — the risk that an entire market will decline. We saw a good example of market risk from the fall of 2008. The good news is that with smart asset allocation, you can reduce some investing risks, specifically unsystematic risk. Investing in any individual stock or bond leaves you vulnerable to the risk that the particular investment could go down in value. Diversification eliminates this risk and gives you the opportunity to make capital gain with one asset class even while another declines. Diversification can’t guarantee a profit or ensure against a loss, but it can help you manage the types and level of risk you take.

When it comes to asset allocation, the biggest decisions come down to how much you should have in cash, bonds, and in stocks. The Fool's four rules for asset allocation will help you slice up your portfolio into these important pieces.

To reduce this risk, investors should consider incorporating lower volatility equity strategies, such as those that focus on identifying companies with stable earnings and consistent dividend growth. Another tactic could be to introduce strategies with the ability to short securities. In a short sale, the investor sells borrowed securities in anticipation of a price decline; the seller is required to return an equal number of shares at some point in the future.

The goals of asset allocation should be twofold: to set a long-term risk and return expectation for your portfolio while reducing the probability of a large loss along the way. It is no surprise that the more risk you decide to take, the higher return you might expect. But asset allocation is also sold as a way to diversify risk. The notion is that each asset class in a portfolio carries different risks, which helps reduce the total long-term risk and smoothens out short-term swings.

Asset allocation reduces the probability of a large loss in a downside market risk, but it doesn't prevent a loss. In an economic downturn your portfolio will go down according to the amount of total risk you hold. There's no getting around it.

The perfect allocation doesn't exist, at least not one that can be known in advance. Some people get hung up on such details as trying to figure out if they should have 30 percent in international stocks or 33 percent. That isn't a question anyone can answer and doesn't make any difference. What really matters in the long run is the percent you have in stocks and the percent in bonds. All else is icing on the cake.