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Game, asset and match

My financial adviser has told me that asset allocation is more important than fund selection when investing capital. What does he mean by this and is he right?

There is something in what your adviser is telling you. Asset allocation is an important and fundamental part of the investment advice process. Historically, investment advisers were accused of moving too quickly through the know your customer process and on to recommending funds. This was probably not too much of a problem in a bullish equity market but, when the bottom fell out of equity markets, the faults in the process became all too apparent.

Today, an investment adviser is likely to spend more time considering the asset classes available and designing a suitable model for you.

There is an argument that says asset allocation delivers a significant part of the total returns achieved in an investment portfolio. So what does your adviser mean by asset allocation? While different people have different opinions, there are fundamentally four asset classes – cash, fixed interest, property and equities.

Each of these asset classes behaves differently and has different attributes which your adviser will explain to you. First, however, the adviser will go through the know your customer process and find out all about you and your investment goals and objectives.

You may be looking for capital growth or income or a combination of the two. You will also need to communicate to your adviser your attitude towards investment risk and volatility. The asset allocation model will reflect your attitude so that there should not be too many surprises for you in the future, even if your investment funds fall in value.

Cash is generally the lowest-risk asset class but it is also likely to be the asset that provides the lowest return. However, cash is useful as an asset in an investment portfolio, not least because it is liquid and can be used when one of those lifetime emergencies arises. It is also useful to have cash to purchase those investment bargains that come along from time to time. The main risk with cash is holding on to too much of it for too long and seeing it eroded in value by the effects of inflation.

Fixed-interest investments – things like government and corporate bonds – usually provide a better level of reward than cash. However, do remember that the capital value of these investment instruments can go down as well as up.

An old rule of thumb used to be that a percentage of your investment portfolio equivalent to your age should be held in fixed-interest securities. So, if you were 57, then 57 per cent of your investments should be in fixed interest. This is both a clumsy and potentially over-cautious approach to investing for growth, particularly in the longer term.

Property – especially commercial property – can be a useful asset to hold. Many advisers build client portfolios without any property element but property might provide both income, in the form of rent, as well as the possibility of capital appreciation of the bricks and mortar itself.

Of course, you might already have big holdings in this asset class – typically your home – but remember that this is residential property and has different investment issues than commercial property.

Finally, shares or equities represent ownership of a business. The reward for the investor is a share of the profits of that business in the form of dividends and the prospect of an increase in the value of those shares based on demand for them among investors.

Asset allocation seeks to mix up these asset classes in such a way as to achieve the investment goals and objectives of the investor. The other benefit of mixing the asset classes is that they tend to behave in different ways under different circumstances. When one is going up in value, it is often the case that another is going the opposite way. This has the effect of smoothing investment returns and, as long as the asset classes are rebalanced over time, the investment returns might be expected to be better than a portfolio that is over exposed to, say, just one class.

Your adviser is therefore wise to give asset allocation the attention it deserves before making specific product or fund recommendations.

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