The total universe of investment opportunities available to the private investor is huge and growing. Stocks, bonds, money market instruments, financial derivatives , alternative investment products and literally thousands of different pooled investment vehicles. Where do you start?
Well, the first question you need to ask yourself is: What are you trying to achieve? In other words, what is your investment aim?
You need to ask yourself what you are trying to achieve because different investment products exhibit different characteristics, both in terms of the returns they offer, and, crucially, in terms of the risks you incur trying to achieve those returns.
The risk/return payoff
The basic principle of risk and return in financial markets is more or less commonsense: the higher the rewards offered the greater the risks incurred.
Looking at it the other way around, the riskier an investment proposition is, the higher the potential rewards need to be to encourage people to take on those risks.
When it comes to risk and return, different asset classes show dramatically different characteristics. Stocks, for example, offer the highest return, but, as we will see, they also carry the highest risk of losses. Bonds dont perform as well, but they offer more stability than stocks (less variability of return). Money-market returns are relatively feeble, but you will never lose your initial investment.
The holding period
The final piece of the jigsaw is the time you want to achieve your given return in, because not only do different asset classes exhibit different risk/return characteristics, those risk/return characteristics change depending on the time you hold the asset for the so-called holding period.
To sum up
An asset allocation strategy is about trying to achieve the blend of risk and return that is right for you, given your investment aims, and the time frame you want to achieve them in.
So, the asset allocation decision will depend on a combination of:
- the expected level of returns available from each asset class
- the expected level of risk associated with each asset class
- your holding period the amount of time you are prepared to wait to get the returns you want.
- and your attitude towards risk
In this section we will look at the different risk/return characteristics of the key asset classes, but first we need to understand the idea of average annual real returns.