Getting to grips with asset allocation, and why does it matter?

The single most important decision you will lever make when it comes to investing is the asset allocation you choose.

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.

Asset Allocation in practice

There are only five things (asset classes) you can invest in: Shares, bonds, real estate, cash and commodities. The mixture of these you choose 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.

What are the different asset classes?

Shares, stocks or equities

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

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.

Real Estate

When it comes to investing, (Core) Real Estate usually refers to commercial (offices), retail (shops and malls), and industrial (factories and warehouses) and in overseas markets multi-family dwellings.

In some definitions, it includes more specialised assets like cell phone towers, data centres and pubs as well as businesses that develop, manage or provide services to this sector. Non-core assets like these increase the risk and blur the lines between real estate and equities.

In practice, most people invest in real estate through Real Estate Investment Trusts (REITS) which trade on stock exchanges.

Don’t confuse this with investing in residential real estate (investment property) or buying your home. These behave differently and serve a different role in your investment portfolio.

Commodities

Commodites include precious metals (Gold, silver and platinum, energy (electricity, oil and natural gas) and agricultural commodities (coffee, grains and meat).

Investors can invest in the physical commodity for immediate (spot) or future delivery (futures), or trade financial instruments (futures and options) or invest in companies that mine or produce those commodities.

Investing in commodities requires skill, so for most individual investors, gold is the primary investment in this class.

Cash

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.

Putting it all together

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.

Some of these asset classes (cash and bonds) tend to produce low but steady returns with a low risk of losing money. We call these Defensive Assets. Others, like shares, can deliver higher returns but with more variability and the chance of losing value. We refer to these as Growth Assets because they are capable of providing returns above inflation over time.

The balance of growth and defensive assets is what determines the risk and return of your portfolio. Your goal is to maximise returns for any given level of risk. 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 at https://lifesherpa.com.au/super/investing_your_super.

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.

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