Too embarrassed to ask: what is asset allocation?

Asset allocation is 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 have 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.

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To take some extreme examples, a young investor saving for retirement a long way in the future and prioritising maximum growth above everything else might have 100% in shares, while a retiree who only cares about achieving a steady income might have 100% in bonds.

More commonly, somebody who wants to achieve a combination of income and growth while also protecting their wealth from bear markets would typically have a portfolio split between different asset classes in a more balanced way.

Asset allocation is often divided into strategic and tactical allocation. Strategic asset allocation is essentially what we’ve already described – how you allocate your money for the long-term to fit your investment goals.

Over time, the amount in each investment may drift away from your strategic asset allocation because some asset classes have performed better than others.

So on regular basis – maybe once a year – you will rebalance your portfolio to take it back to your original strategic asset allocation.

Tactical asset allocation is any temporary change that you make to a strategic asset allocation as a result of current market conditions.

If shares sell off a long way and now look cheap, you might choose to reduce the amount of cash you hold and increase your investment in shares.

Profiting from tactical asset allocation is harder than it sounds, and doing it too much can easily lead to higher costs and lower returns.