Asset allocation is the process of deciding what proportion of an investment portfolio should be invested in:
- different types of investment (shares, bonds, real estate etc.),
- in what markets (what regions and countries, how much abroad, how much in emerging markets etc.),
- in what sectors,
- the proportions invested in large cap or small cap companies.
The reasons why good asset allocation improves diversification should be fairly obvious. It helps ensure that investments are spread out across a wide range of markets and securities, and the allocations should be chosen to avoid investing too much in markets and securities whose movements are strongly correlated with each other.
Asset allocation can boost performance by identifying markets or sectors that are undervalued as a whole. Correctly identifying these will clearly improve performance. These are also more likely to contain individual securities that are undervalued.
Proponents of asset allocation claim that the main driver of investment returns are at market and sector levels. Proponents of bottom up investing tend to argue that the biggest potential gains come from the movements in the best performing individual securities. Both are true, and the choice of approach ultimately tends to depend on how confident and investor is in their ability to pick stocks.
How assets are allocated depends on a number of factors:
- an investor's views on which markets and types of securities will outperform, this depends on views on economic growth and interest rates,
- the need to diversify,
- the aims of the portfolio,
- what assets an investor owns outside investment portfolios.
Investors who rely heavily on asset allocation are using a top down approach.