What is an asset allocation?
Asset allocation is the mix of investment types that make up your portfolio. Investment types can be split into categories which are also known as asset classes. The generally recognised asset classes are:
Diversified fixed interest*
*Note: Diversified Fixed Interest includes Australian Fixed Interest, International Fixed Interest and credit. Alternatives can include allocations to commodities, CTA funds, global macro and diversified alternatives etc.
Why is asset allocation important?
Most investment experts will tell you that your asset allocation is the single most important factor in the returns that your portfolio will generate. It’s widely recognised that for most investors, it’s the asset allocation (rather than the actual investment products) which make the difference between a poor or a good return.
While not as visible as returns, the right asset allocation will help to reduce the risk within your portfolio.
Return and Risk Return
For many people, investment objectives are about growing their funds to meet specific goals, for example, buying a home, becoming free of debt or providing for retirement. In most cases, success in reaching your goals will be largely dependent on returns. You will require your investments to deliver sufficient returns to achieve your goals. Return can be in the form of income or growth.
- Income returns include dividends received on shares, coupons paid from bonds, interest earned on bank term deposits and rental income on property.
- Growth returns include the rise in value of shares or the increase in value of a property you hold.
Some investments only provide income returns (for example, bank term deposits) whereas other investments, such as shares and property, generally provide both income and growth returns. For example, shares in a large company usually pay a dividend (this is the income return) and may increase in value over time (this is the growth return). In these cases, the total return is calculated as the income return plus the growth return.
If a share is worth $10 when you buy it and $11 a year later, the growth return is 10%. During this period, a dividend of 40 cents may also be paid to you which is an income return of 4% on your $10 investment.
Risk has a number of different definitions but it is commonly thought of in three ways:
The probability of losing your initial investment. For example, there’s a risk that the company you invest in could be poorly managed and you could lose your total investment. This scenario is highly unlikely to occur with investments in large companies, but it does happen occasionally (for example, HIH Insurance, Enron).
The probability of not receiving your expected growth return. For example, there’s a risk that the share price of the company you invest in could go down to $8, rather than up to $20 as expected.
The probability of not receiving your expected income return. For example, there’s a risk that the company you invest in may only pay a dividend of 15 cents, instead of the expected dividend of 40 cents.
A low risk investment has a low probability that these events will occur. For example, a fixed term deposit with a bank is low risk. From the start, you generally know how much income you’ll receive (that is the interest rate) and that you’ll get your initial investment back at the end.
Shares and property investments are considered to be higher risk investments as there is greater probability of capital loss or of not getting the returns you expect.
Risk and return always go together
While everyone would like to maximise return and minimise risk, and would love to have a return every year of 20% with no chance of investments falling in value, the reality is that these investments don’t exist.
People are not averse to risk but rather they have an aversion to loss. Put simply, this means that people are often more sensitive to losses incurred than they are to gains received.
Some investment products offer the potential of higher returns, but with these products there is always a higher risk of your investment falling in value. For example, Australian shares increased by 45.4% in 1993, but fell by 40.4% in 2008.
At the other end of the spectrum, a bank term deposit will offer a low risk strategy as the value of your investment is unlikely to fall. But while the value of your investment is unlikely to fall, the return offered by the bank for that term deposit will be low, relative to potential returns from other, higher‐risk investments.
To obtain higher returns you must also be prepared to take on the higher risk of your investment falling in value. If you are not prepared to take on the higher risk, then you will need to accept lower returns on your investments.
Selecting the right asset allocation
The right asset allocation will vary from person to person and is dependent on your personal circumstances and investment goals. The three most important factors are:
- How long do you have to invest? Will you need access to your funds in a few years or can you leave them invested for many years?
- What returns do you want to achieve? Will you meet your investment goals if you only achieve a return of 10% per annum or do you need investments that can provide 8% per annum?
- How much risk are you prepared to accept? Would you be comfortable if your portfolio could fall by up to 5% over your investment time frame? What if, in any one year period, it could fall by more than 20%?
Your personal tolerance to risk and volatility is an important consideration here. Two investors with the same investment goals and investment time frame can have different asset allocations and both may be appropriate simply because they have different tolerances to risk.
Once you understand your personal circumstances, your aim should be to either:
- determine the level of risk you are prepared to accept and then seek to maximise the return on your portfolio; or
- determine the return you would like to achieve and then seek to minimise the risk required to achieve this return.
With this understanding, your financial adviser will take you through the Risk Pro ling tool which will help you to select a suitable asset allocation.
Interested in speaking with a financial adviser?
Contact Capital Advice Partners on 02 8920 3488 or use the form on the right today.