Asset allocation is perhaps one of the most critical investing strategies you can employ. It’s not just about diversifying within a single portfolio – it's about strategically positioning your investments across all your portfolios or accounts, optimising for returns and managing risk.

In this month’s newsletter, we’ll dive into how you can develop a comprehensive, holistic asset allocation strategy that accelerates the way you build your wealth.

True diversification or mere illusion?

We've all heard the adage, "Don't put all your eggs in one basket." In investing, this translates to diversification – the only free lunch on Wall Street.

True diversification goes beyond simply holding multiple portfolios. It's about spreading your investments across different asset classes to reduce overall volatility, and within asset classes to mitigate sector and country-specific risks.

But beware the diversification illusion. Many investors believe they're well-diversified simply because they have multiple accounts or portfolios. However, if these portfolios contain similar or overlapping assets – like mutual funds or ETFs heavily invested in the same large-cap stocks or bonds – you're not reducing risk; you're concentrating it. The key to genuine diversification is to look at the underlying assets in each portfolio.

Different goals require different asset allocations

Your ideal asset allocation ultimately comes down to your unique financial goals, time horizon, and risk tolerance. Different objectives – like retirement savings, purchasing a home, or funding education – each require their own distinct strategy.

If you're saving for a downpayment in the next 2-3 years, your asset allocation might be more conservative, focusing on stable, liquid investments. On the other hand, your retirement portfolio, with a time horizon of 20 or more years, can afford to be more aggressive, with a higher allocation to an asset class that benefits from a longer runway.

When you have various goals, some overlap in your investments is inevitable and perfectly acceptable – what's important is defining those goals, so you can determine the appropriate mix of asset classes for each, and keep track of them separately. 

Core stability, satellite flexibility

The chart of asset class returns earlier vividly illustrates how differently they perform across various market cycles, underlining the importance of a holistic asset allocation strategy. Seminal research, including the study Determinants of Portfolio Performance, have found that asset allocation is responsible for upwards of 90% of a portfolio’s returns over time.

Successful long-term investing thus lies in a well-designed core portfolio. This core, typically comprising broadly diversified index funds or ETFs, forms the bedrock of your investment strategy, providing consistent exposure to major market segments.

The core-satellite approach then introduces the flexibility to pursue targeted opportunities. Satellite investments – which might include thematic ETFs or alternative assets like venture capital – allow you to express your views on particular sectors or trends, potentially enhancing returns without compromising the overall stability of your portfolio.