What is a balanced portfolio?
A balanced portfolio is one that spreads its investments across different asset classes to control risk and achieve moderate growth. Although risk management is its key purpose, and steady growth the usual outcome, it can still outperform expectations in some market conditions.
Achieving a balanced portfolio is largely the result of asset allocation.
What is asset allocation?
Asset allocation is the foundation on which a portfolio like this is built. It's a strategy for investing in the asset classes that will best align your investments to your financial goals and risk appetite.
The decisions you make about asset allocation largely determine a portfolio's risk profile and expected growth.
What are the asset classes?
Asset classes are the different types of assets you can invest in. The most common are:
- Equities – Commonly known as shares in the UK, an equity is a higher-risk asset class, which provides a share of the ownership in a company.
- Bonds – Considered lower risk, a bond is a loan to a company or the government that generates income through interest payments.
- Property – Considered moderate-risk, you can invest in property either through physical assets or, more commonly, through property funds.
- Cash (and cash equivalents) – Considered low risk and easily accessible without losing value, cash and cash equivalents (such as gilts and Certificates of Deposit) are generally treated as short-term investments.
- Commodities – Considered a high-risk asset class, commodities cover anything that's used to produce something else, such as grain, oil, and precious metals. As they behave differently to equities and bonds, they can help improve diversification.
A mixture of these asset classes can help towards building a balanced investment portfolio.
If building a portfolio with a diverse range of assets feels daunting, there are multi-asset funds available. These funds contain a pre-selected mixture for you to invest in, providing a shortcut to diversification.
You can choose a fund suited to your goals and risk appetite, without the need to allocate the assets yourself. The fund manager has this responsibility.
Keep in mind that the value of your investment can go down as well as up, so you could get back less than you invested.
Why is asset allocation important?
Asset allocation helps to spread risk. A balanced portfolio is one that successfully spreads risk. This is important, because whether you invest in a fund, individual shares, index trackers or something else, there's always the potential to lose money.
It helps diversify and balance your portfolio. This is so you're not relying on the performance of one company, one asset class, or one sector. It's ensuring all your eggs aren't in the one basket. That means if one or more investments fail, there are others to help your portfolio recover.
Asset allocation is also important for keeping your financial goals on track.
How do you build a balanced portfolio?
There are a few things to consider when allocating assets for a balanced investment portfolio. These are outlined below:
- Risk appetite
- Investment term
- Financial goals
Risk appetite is how comfortable you are with potential losses and market volatility. Do you think the potential rewards are enough to make the higher risk acceptable? Once decided, your risk appetite can be expressed in your asset allocation. This will be the amount of higher-risk assets that make up the portfolio, compared to lower-risk ones.
Investment term is how long you're prepared to stay in the market for. This will have a bearing on your asset allocation. A longer-term investor will potentially have recovery time, if higher-risk assets suffer losses. A shorter-term investor won't have recovery time on their side and may need to sell their investments at short notice. They will probably target what are considered safer, more stable assets, such as bonds or cash.
Financial goals cover how you tailor your investment portfolio to your objectives. Whether it's buying a home, investing for retirement, or generating passive income, your asset allocation should reflect this. For example, if you're looking to invest for retirement, higher-risk, long-term investments may play a key role in your portfolio. Or if you're after an income from your portfolio, you may favour the interest payments of bonds or equities that offer dividends.
Building a portfolio based on risk appetite
A common way to build a balanced portfolio is to base it on your risk appetite and risk tolerance (the amount you are prepared to lose).
Low risk
A low-risk portfolio would prioritise the preservation of your investment above growth. This would typically include a much higher proportion of so-called 'safer' assets, such as bonds and gilts. There would be a lower proportion invested in equities. Its value tends to fluctuate less than the other risk profiles, offering more stability but less growth potential.
Moderate risk
A moderate risk portfolio would aim for a moderate amount of growth while controlling the risk to your investment. This could mean a mix of equities, bonds, property and some other asset types, spread across different regions and sectors. The value of the portfolio may fluctuate moderately. This would reflect the balance between its growth potential and the preservation of your investment.
High risk
A high-risk portfolio would seek greater rewards through riskier assets. It would usually try to achieve this via a higher proportion of equities, possibly commodities and other higher-risk, higher-reward assets. The potential for higher returns over the long term comes at the cost of exposure to market ups and downs. This could lead to the value of the portfolio fluctuating over time.
Rebalancing your portfolio over time
Rebalancing your portfolio involves adjusting the mix of assets over time. It is an important part of asset allocation. The reasons for doing this might be periodic or event driven.
Periodic rebalancing is something you may wish to do on a fixed basis, such as quarterly or annually. It helps to keep the asset allocation aligned with your long-term goals and prevent portfolio drift. This is where your portfolio shifts away from its initial target due to asset performance.
- Event-driven rebalancing is reactive, with reasons including:
- The risk profile of your portfolio has changed
- Your financial goals have changed
- Unforeseen circumstances or life events.
Change of risk profile – Market movements over time can shift the balance of your portfolio. This is because the values of the assets within will change at different rates. For example, if equities perform better than expected, they may make up a larger proportion of your portfolio than originally intended. The individual assets won't have become riskier, and your asset allocation will remain the same, but the actual composition of your portfolio may now behave differently. This could increase its overall exposure to market ups and downs. Rebalancing can adjust the portfolio back to your original allocation plan. This will keep it aligned with your risk appetite and financial goals.
Change of financial goals – Your financial goals may change over time. Whereas once your objective was long-term growth, you may have shifted your focus to income generation. If your financial goals change, you will need to adjust your asset allocation to suit. Rebalancing your portfolio can help to ensure it remains aligned with your current financial goals, rather than the ones you had at the start.
Unforeseen circumstances or life events – Events beyond your control can sometimes affect your investment plans. Whether a major expense needs covering, such as buying a home, or something unforeseen occurs, such as losing a job, you may require access to funds. Whatever the reason, your financial priorities may change. When such events happen, your asset allocation may no longer serve its purpose. Rebalancing can help adapt your portfolio to your new circumstances.
However you choose to build a balanced portfolio, it's the core principles of balancing risk, aligning with financial goals, and rebalancing over time that remain central to any approach.