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There is a lot of research around how much asset allocation decisions contribute to overall investment returns. Some studies say it could be as high as 90%, whereas others suggest it might contribute 70%.
Either way, it is a significant factor that retirees need to consider when putting together their investment strategy.
What is asset allocation?
Asset allocation is how you allocate your investments across a range of different assets. If you had $100 and split that evenly between assets A, B, C and D, your asset allocation would look like this.
For most investors and retirees, the asset classes they invest in will include equities, property, fixed income and cash, infrastructure and alternatives such as hedge funds and private equity.
Different asset classes have different risk and return properties and will usually be classified as either growth or defensive.
- Growth assets are higher risk with higher returns that may be volatile in the short-term.
- Defensive assets are lower risk with steady, lower returns
Equities, property, infrastructure and alternative assets (like private equity) are usually considered growth assets, while fixed income and cash are considered defensive.
The difference between asset allocation and diversification
Asset allocation is where you put your investments, while diversification is how you spread your money across the investments available to you.
By diversifying across a number of non-correlated assets you are able to reduce the volatility of your portfolio. For example, shares and investment-grade bonds are generally un-correlated and a correction in the equity market will (usually) not impact the fixed income market. Therefore, if your portfolio was invested across equities and fixed income (along with other assets) your fixed income investment could compensate for some of the loss in your equity investment during a sharemarket fall.
This practice of considering diversification in portfolio construction is called Modern Portfolio Theory.
The importance of rebalancing
All SMSF trustees are required to have an investment strategy that states their intended asset allocation. But even if you don’t have an SMSF, it’s a good idea to create an investment strategy for any investment portfolio that lays out what percentage you intend to invest in each asset class. An investment strategy is important as it keeps you on track.
You will also need to rebalance your investments from time to time to bring them in line with your stated asset allocation objectives. Often if a particular investment or asset class rises or falls in value, the proportion it represents in your portfolio will change.
If the equity portion of your portfolio has risen in value, for example, it may take up a much larger allocation of your overall investments than it was intended to. You may therefore need to sell down some shares and buy some bonds to rebalance your portfolio. It’s important to review your portfolio and rebalance at least once a year if necessary.
How to create the right asset allocation for you in 5 easy steps
Step 1: Before you start considering your asset allocation you need to have some understanding of your risk profile. If you’re unsure of your appetite for risk, our risk profile quiz could help. It’s a very simple survey but it should give you some idea of where you sit on the risk spectrum.
Step 2: Your risk comfort level will help you understand how much you should invest in growth assets, such as shares, and how much in defensive assets, like cash and fixed income. The allocation used by many large superannuation funds as their ‘balanced’ and default investment option includes a 70% allocation to growth assets and a 30% allocation to defensive assets.
Here is a typical split between assets for a large super fund’s balanced option.
|Infrastructure & Private Equity
|Cash & Fixed Interest
Step 3: You also need to consider your life stage. If you are already retired, then you will need to focus your investment strategy on assets that provide income. If you are still in accumulation phase and some way off retirement, you will be able to invest more in growth assets because you have time to ride out the ups and downs of market cycles.
Step 4: Consider the time you have available to research potential investments and whether or not you will be able to comprehensively research individual companies. There are investments, such as exchange traded funds (ETFs), that can take care of some of the legwork for you.
ETFs like the BetaShares Australia 200 ETF and the SPDR S&P/ASX 200 Fund will give you access to the ASX/S&P 200 without having to invest in every single one of the top 200 companies’ shares. Similarly, there are global ETFs listed on our local exchange that provide access to some of the biggest international companies in Europe, US and Asia.
Step 5: Finally, if you don’t have an SMSF and are required to have an investment strategy with your stated asset allocation, it is still a good idea to document your asset allocation and your reasons for it. It helps keep you accountable when tempting ‘sure-thing’ investments come up and also reminds you to rebalance on a regular basis.
If, as studies suggest, asset allocation is one of the most important factors in your portfolio’s performance, you need to sit down and give it the attention it deserves when developing an investment strategy.