When saving for a long-term goal such as retirement, most people invest their money in financial markets, rather than just putting it into a savings account in the bank.
Because in the long term, history suggests that your money will grow more quickly over time if it is invested in financial assets such as shares or bonds, than if you leave it in cash.
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There is, of course, a snag here.
When you put your money in cash, it doesn’t go up and down on a regular basis. Its value might be eroded by inflation – for more on that, watch our previous video on “real returns” – but you won’t wake up one morning to find that you suddenly have 10% less cash in the bank than you did the previous day.
The value of publicly-traded assets such as shares or bonds, on the other hand, fluctuates on a daily basis. In the long term they may deliver better returns than cash, but the journey will contain a lot more ups and downs.
Also, there are certain economic environments in which certain types of asset will tend to do better than others.
So how do you balance the fact that you don’t know what’s going to happen in the future, with the need to grow a pot that’s big enough to fund your retirement?
This is where asset allocation comes in. Asset allocation is simply the process of dividing your portfolio between different asset classes, such as shares, bonds, property, cash and gold.
Each of these asset classes should behave in different ways in different scenarios, and offer different potential risks and returns.
The aim of asset allocation is to blend these together in a way that produces a combined level of risk and return that best suits an investor’s needs.
Typically, the younger the investor and the longer they have until they plan to retire, the more money they would have in shares. Shares are the most volatile assets, but they also tend to deliver the best long-term returns.
By contrast, the shorter the time horizon, the more an investor might traditionally have held in bonds. Asset allocation will also take into account an individual’s appetite for risk – in other words, just how many ups and downs they can stomach along the way.
That said, more and more people are now questioning traditional asset allocation due to today’s unusual economic backdrop of ultra-low interest rates. Lengthening lifespans also make a difference. Investors looking forward to longer retirements may need to remain invested in shares for longer than was once recommended.
To find out more about shifting approaches to asset allocation, subscribe to MoneyWeek magazine.
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