The Essentials of Managing Risk: Asset Allocation & Diversification

To achieve long-term financial success, unit trust investors need to practise both proper asset allocation and diversification. An investment portfolio that is properly allocated and diversified can help investors manage risk by reducing its overall volatility.

Asset Allocation

Asset allocation is the process of apportioning investments among various asset classes, namely equities, bonds and money market instruments, so that the portfolio is invested in the appropriate combination of these asset classes. Table 1 shows the key characteristics of such asset classes.

Table 1: Key characteristics of selected asset classes

The asset allocation that works best for an investor at any given time will depend largely on the investor’s investment objective, risk profile and return expectations.

Investors who seek capital growth over the long term can focus their investments in equities. However, this group of investors should be prepared for higher risk as equity funds offer potentially higher returns with greater price volatility.

Meanwhile, risk-averse investors who seek income and stability of principal should allocate their investments more towards bonds and money market instruments. A combination of asset classes that do not move in the same direction will reduce the portfolio's sensitivity to market volatility. If a portfolio comprises both equities and bonds, adverse movements in equities may be partially mitigated by the steadier performance of bonds.

By practising proper asset allocation, investors will more likely be able to manage market risk. Market risk refers to the change in the value of investments over time due to changes in the economic outlook, interest rates and inflation rates as well as other events such as political changes or natural disasters. 

Diversification

To achieve a well-diversified portfolio, investors should spread their investments across different markets, sectors or asset classes that generally do not move in tandem with each other. It is also prudent to include funds invested across various geographical locations to cushion the performance of the portfolio against risks specific to particular countries or regions.

In contrast, an undiversified portfolio with funds concentrated in only one or two asset classes or markets may be significantly impacted during periods of elevated volatility in the respective assets or markets.

Conclusion

To ride through market volatility, investors should practise proper asset allocation and diversification to achieve their desired long-term financial goals. Without a fundamental understanding of asset allocation and diversification, investors may be tempted to make unwise decisions about their portfolios, especially during periods of exceptional market movements.

Over time, the asset mix in an investor’s portfolio may shift from its original allocation as a result of prevailing market conditions. In such circumstances, periodically rebalancing the portfolio would help the investor to realign the portfolio back to an asset mix that reflects the investor’s investment objective, risk profile and return expectations.

This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.