Asset allocation: Intro
In this section, we will dive into asset allocation and we will start examining its role in portfolio risk management.
What is asset allocation?
We have seen what a portfolio is and what asset classes are. Now, we will look a little deeper into the composition of a portfolio by learning what asset allocation is. It simply is the proportion of all the asset (or asset classes) that you own in your portfolio; or, in other words, the percentage that each asset (or asset class) takes up of your total capital invested. It is the most important ingredient in investing because it helps you mitigate investment risks and achieve your return objectives.
Let’s continue with Laura’s example to clarify this:
In the previous section, we analyzed Laura’s three investments and we saw that she decided to invest $500,000 in each one for a total invested capital of $1,5 million:
- SmartPies, Inc.: $500,000 invested / $1,500,000 total invested capital = 33.33% of total investment capital
- Baguette bakery: $500,000 invested / $1,500,000 total invested capital = 33.33% of total investment capital
- Rental Property: $500,000 invested / $1,500,000 total invested capital = 33.33% of total investment capital
The above represents Laura’s initial asset allocation. She evenly distributed her investment capital (money available to invest) into the three assets.
Remember, in the previous section, we saw the comparison of the future performance of the three assets (shown above). Now, we are going to take a look at all of them combined to get Laura’s portfolio performance (shown below):
We simply added up the money invested in each of the assets and plotted a separate chart for the result, which is Laura’s portfolio. Below is the table we created that shows the performance of the three assets and the overall portfolio:
$ values in thousands (add “000”)
As we have previously seen, Laura has invested $500,000 in each asset. The above table shows the future numerical performance of each asset since Laura started investing, in 2020. For example, at the end of 2025, we see that SmartPies will be worth $670,000, Baguette Bakery will be $650,000, the Rental Property will be $680,000. All those add up to $2,000,000, which will be Laura’s portfolio value at that time. And in 2030, ten years after her investment, she will have $2,435,000. Now, let’s do some math to find out what the total profit percentage is:
- SmartPies Total Return: ( Ending Value of $760,000 / Beginning Value of $500,000 ) – 1 x 100 = 52.00% SmartPies Total Return
- Baguette Bakery Total Return: ( Ending Value of $800,000 / Beginning Value of $500,000 ) – 1 x 100 = 60.00% Baguette Bakery Total Return
- Rental Property Total Return: ( Ending Value of $875,000 / Beginning Value of $500,000 ) – 1 x 100 = 75.00% Rental Property Total Return
Now, we add up all three Ending Values and divide them by the total Beginning Value as follows:
- Portfolio Total Return: ( Ending Value of $2,435,000 / Beginning Value of $1,500,000 ) – 1 x 100 = 62.33% Portfolio Total Return
Now, you have a clear understanding of what a portfolio is, what asset allocation means and how to calculate it. In the next section, we will dig even deeper into asset allocation and see why it is so important.