In Finance, an 'Asset Class' is a group of financial instruments that have similar characteristics and behave similarly in their marketplace. Instead of holding Cash (which is an Asset Class) in our bank accounts, we could own assets that are in other Asset Classes.
‘Asset Allocation’ in simple terms is the practice of dividing our financial resources (i.e. Cash) into different categories of Asset Classes. Investment Advisory Firms have similar but slightly different categorization of Asset Classes. It’s not necessarily a precise concept. But, for the purpose of this site, I will categorize asset classes into the following core buckets:
Cash & Cash Equivalents
Equities or Stocks or Shares
Bonds or Debt
Real Estate
Precious Metals and Commodities
Alternative Investments
It is important to define and stick to a categorization. This will help later in clearly identifying, allocating and tracking your investments.
The income you receive from your employer or from your business is deposited to your bank account after paying taxes. This is cash in a digital form placed in your bank account. If you made no investment with it, the cash simply sits around idle. We will refer to this as ‘Idle Cash’. You may want to set aside some portion of this Idle Cash to meet your monthly expenses. I recommend holding a further ‘Cash Buffer’ for a rainy day. We will refer to any amount you now have left after paying your expenses and holding a buffer as ‘Surplus Cash’. You should aim to invest some or all of your Surplus Cash in the various Asset Classes.
The approach of dividing up your Surplus Cash into investments in the different asset classes is called Asset Allocation. The approach you follow should reflect your personal goals and your risk tolerance levels.
Every Asset Class can be further sub-divided into more categories. The table below shows a broad sub-categorization we will follow through this site. Allocation to the subcategories within an Asset Class provides diversification benefits. We will discuss the risk and return profile for each Asset Class and its sub-categories in more detail later.
To summarize:
Assume you earn £1,000, which is deposited in the bank. This is your Idle Cash.
Assume your monthly expenses are £400 and you want to hold a Cash Buffer of £200. This will leave a Surplus Cash of £400.
The process of dividing up the £400 of Surplus Cash across the different Asset Classes in line with your objectives and risk tolerance is called Asset Allocation.
The allocation to an Asset Class can be further divided into its sub-categories. This provides diversification benefits.
In this series, we will:
Create a framework through which you can identify your objectives, risk tolerance and investment horizons
Discuss each Asset Class and its sub categories in detail; We will focus on risk vs return for each Asset Class
Devise an Asset Allocation strategy that you may use to financial plan your future. This will be based on trying to match your risk vs return preferences to a combination or portfolio of the various Asset Classes.
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