Understanding Asset Allocation

As it turns out, the biggest driver of investment returns (before fees) is the type and mix of assets you choose. In other words, how much of your money you invest in shares matters more than the amount you allocate to (say) Telstra. Money managers call this asset allocation.

There are only 5 classes of things or assets that you can invest in. I call these the 5 B’s of investing. The first two B’s are Bricks and Businesses. They’re both capable of delivering high returns over the long term (although this varies significantly in the short term) and so we call them growth assets. The next three B’s are Bullion, Bonds and Bills. These assets are more likely to generate lower but steadier returns so we call them defensive assets. The mixture of these drives the risk you take and the return you can expect. It matters more than any other decision you make. Your goal is not to beat the market; it is to maximise your returns for the level of risk you are willing to accept.

Each of these asset classes behaves differently and so has a unique role to play in your portfolio.

A winning portfolio is not the same as portfolio of winners—diversification matters.

A share is simply a unit of ownership in a company and the underlying business. The value of that share is a function of the performance of the underlying business and changes to the market’s opinion of it. Great businesses don’t always make great investments especially if the market has too high an expectation of it.

Shares generally trade on public stock markets and so are liquid and display a high degree of price transparency.

Investors get rewarded for holding shares by dividends paid by the company (dividend income) and changes to the market value of the company (capital growth).

Diversification within the share asset class comes from industry, geography, size and quality. By investing across different industry sectors, you can benefit from various economic cycles, regulation and currencies. Small companies tend to be riskier than large companies and so generally deliver higher returns to compensate investors.

Bonds are units of ownership in loans to Governments, companies and other entities. A bond investor gets rewarded by regular interest payments (coupons) and return of their capital (generally on maturity, although occasionally each coupon also includes some principal). Historically, the coupon or interest rate was fixed for the duration of the bond and so they are often referred to as Fixed Income securities.

Credit quality and duration are the two main drivers of bond returns.

Credit quality is the probability that the issuer will default on its obligations to pay interest or principal repayments when due. It is usually quantified by a credit rating issued by one of three ratings houses (Standard and Poors, Dunn and Bradstreet and Fitch). High quality or investment-grade bonds are usually rated on a scale from AAA to BBB+. Bonds rated below this are known as junk or high yield bonds. Lower rated bonds generally offer a higher return.

Duration is the time from issue to redemption (adjusted for any repayments of principal during that period).

A longer duration will generally offer a higher return for two reasons.

Firstly the longer the term the greater the chance of something changing that might result in the issuer not being able to pay the coupon or redeem the bond.

Secondly, the interest rate risk is higher for the longer duration. As the interest rate on the bond is fixed for the term, its value will fall if market interest rates rise and rise if market interest rates fall. As the duration increases, this effect becomes more pronounced.

Returns are generally higher for lower credit quality issuers or longer durations to compensate for the higher risk of the borrower defaulting on their payments.

Investing in cash is the most certain of the asset classes and generates it’s return from interest. You can invest in bank deposits which usually attract a Government guarantee. Bank deposits can be “at call” or for a fixed period (term deposits).

Cash as the lowest risk also offers the lowest return, which often falls short of inflation, and is unsuited for long term investing.

You need to build your portfolio from these components based on what you are trying to achieve, your time frame and your attitude to risk.

Defensive assets tend to produce low but steady returns with a low risk of losing money. Growth assets can deliver higher returns but with more variability and the chance of losing value. They are capable of providing returns above inflation over time.

Accordingly, you need enough growth assets to deliver the return you need coupled with enough defensive assets to allow you to sleep at night and keep your hands off the sell button when turbulence strikes the market.

A high growth portfolio (sometimes called aggressive) would suit a long term investor with a high-risk tolerance and might consist of 90% or more growth assets, with less than 10% in cash or bonds.

On the other hand, a conservative investor with a short time horizon would look for a high allocation to defensive (65%+) and only a small portion to growth assets. You can read more about portfolio allocations in this article.

Once you’ve selected your asset allocation, you can then choose which assets or indexes to invest in and finally a group of managers or securities.