When I was new to investing, the one thing that excited me most
was discovering potential stocks. That’s because there’s only
upside, right? Well, it took a severe fall in the price of a stock
I owned to realise that reducing my risks as far as possible is
equally important in protecting the inevitable downside that all
investors will face.
The case for asset allocation
It is easy to say I want to hedge my investments. This is
something that I suppose everyone know they must do, but how is it
done in practice? One way is through the careful allocation of
So how does it work? Before delving into that, let’s consider the three main asset classes we are all most familiar with:
These assets face different risks. Cash faces the risk of inflation which essentially means that the value of your money shall erode over time. Meanwhile, bonds face interest rate risk, default risk and valuation risk. And then there are stocks, which may be vulnerable to valuation risk and headline risk. Risks such as these may cause the value of your investment to change over time.
These risks may be unavoidable, but you can choose to manage risk by thoroughly planning the proportion of assets in each category. This falls back into the main aim of asset allocation – to keep risks low and to diversify. How this works is that you hold assets with a different correlation to each other, which means that their prices do not move in tandem with each other.
The classic example of this is stocks and bonds. Usually, when the value of a stock falls, the value of a bond rises as investors move to “safer” investments. But when bonds fail to perform well in a rising interest rate environment, holding cash could be an alternative. However, it is widely recognised that stocks offer investors the best long-term returns through economic cycles.
In such a way, the three classes shown above can nicely balance each other out in reducing the overall downside.
This is not just limited to the asset classes. Within the asset class itself, you might also find that assets involved do not necessarily move together as well. For example, you might want to contrast small-cap stocks with large-cap stocks or US stocks with Hong Kong/China stocks.
By splitting your money across assets where prices don’t move together, it is possible to avoid severe dips in the value of your overall portfolio. Admittedly, some people might argue that holding different asset classes reduces the downside potential but also limits the upside potential. That may be true but this leads me to my next point.
Knowing yourself: Risk, returns, behaviour and objectives
The kind of portfolio you choose to hold should ultimately be
decided by you because only you know best what kind of returns and
risks you are willing to accept. While high returns can be
desirable, the associated risks may not be something that you are
For example, a portfolio which gives you high potential returns/losses due to its high volatility may not be suitable for someone who prefers a stable income without taking on too much risk. A case-in-point is retirees, who might invest solely for capital preservation and depend on a steady income from it.
On the other hand, someone who is younger and has a presumably longer investment runway might have a much larger appetite for risk and the time horizon necessary to wait out any prolonged downturns. In that case, perhaps the same aggressive portfolio talked about above might be suitable.
Thus, while you might look at asset allocation as a guideline to temper risks, any asset allocation you choose to hold should, more importantly, be tied to the kind of risk-reward ratio that best aligns with your own investment objectives.
by Hui Yi Tee, English Writer @ FIGS
16 Nov 2018
(Please note that all views expressed in this article are solely my own and do not represent the opinions of FIGS or its related companies)
The information contained in the FIGS Blog is for your general information only and is not meant to constitute professional and/or financial advice. Please note that the use of the FIGS Blog is subject to the Disclaimers.