Whether you’re new to investing or a seasoned pro, strategic asset allocation is a crucial part of building a strong investment portfolio. It will create the foundations of your portfolio and can help guide future investments.
Not sure what asset allocation is? Without even realising, you may already be familiar with asset allocation in our everyday lives. A quick example would be a business operating as a street vendor who sells both sunglasses and umbrellas. Chances are, they wouldn’t sell them at the same time. However, it’s great to have both in stock because people want umbrellas when it’s raining. And by having both items on hand, the owner reduces their risk by having something to sell, regardless of the weather.
What is asset allocation?
Asset allocation is a way of balancing risk by dividing the portfolio assets among different categories, commonly referred to as classes. These can include bonds, stocks, cash, real estate etc. Each of the allocated asset classes have varying levels of risk and return, meaning each will behave differently. One asset may continue to increase in value while another decreases, or doesn’t increase as much, over time.
Have you ever had a pie chart or graph on your account statement? It looks something like this:
It’s likely that the pie chart is displaying your portfolio’s asset allocation. Over time, they’ll change but the pie chart is a great visualisation of the diversity of your current investments.
The allocation of assets can be managed in two different ways - strategic asset allocation and tactical asset allocation.
Strategic asset allocation – a long term approach to investing based on the three key elements of objective, risk tolerance and time horizon. Changing markets mean portfolios need to be regularly reallocated in line with the investor’s investment objectives, current risk tolerance and the time frames for their financial objectives.
Tactical asset allocation – an active, hands on management approach. Requires constant monitoring to see how the investments are performing and moving around the ones that under-perform.
Types of asset classes
There are two general asset types – defensive and growth.
Defensive – generally more stable and less likely to lose money. But the return on investment (ROI) over the long term will be lower. Cash and bonds are common defensive assets.
Growth – riskier investments, especially over the short term, but with higher expected returns. Shares, real estate (property) and commodities.
There are a number of asset classes to choose from, which is where the importance of strategic asset allocation comes into play. Understanding the classes and their features will help you make strong, informed choices.
Cash – includes money in bank deposits. A stable investment with steady returns but its value fluctuates because of changing interest rates. Returns tend to be the lowest of all the asset classes but are a safe place for funds when the markets are shaky.
Bonds (fixed interest stocks) – issued by governments and companies wanting to borrow from investors. Historically less volatile so returns are modest. They pay fixed level interest. High risk borrowers pay more in interest.
Shares (equities) – usually the highest risk with the highest returns but not all shares are created equal. However, investors who can successfully ride out the volatility of the stock markets have achieved the best returns over time.
Property (real estate) – global pandemic notwithstanding, both residential and commercial property have a good track record in offering financial return. Investing in ‘bricks and mortar’ is a time honoured Australian tradition and, even during a global pandemic, our property market is holding fast. Buying shares in real estate investment companies and property developments are another way to invest in real estate.
Commodities – Gold and silver. Oil and gas. Copper and iron. Wheat and barley. These are all examples of investment commodities. Like bonds and shares, prices rise and fall in response to supply and demand.
Why asset allocation is important
There are some who argue a balanced portfolio will only ever deliver average results. However, for most investors, this balance provides protection against big losses should any one investment start to wobble.
Most financial advisors, including the Kelly+Partners Private Wealth team, agree that strategic asset allocation is the best way to build and maintain a strong investment portfolio while diversifying risk. In fact, how you allocate assets is actually more important than the assets you decide to invest in. A mix of low and high risk stocks along with long term bonds and cash is the way forward for a truly diverse, strong portfolio.
Factors to determine asset allocation
As mentioned above, the three key factors in determining your strategic asset allocation are investment objectives, risk tolerance and time horizon.
Investment objectives – what are you trying to achieve with your investments? Short term gains or long term security? Or a bit of both.
Risk tolerance – how much are you prepared to risk? Are you an aggressive investor prepared to take greater risks for greater returns? Or are you looking for safe investments with lower returns? While there’s benefits to both approaches, it's up to the individual investor (and their financial advisor) to determine what works best for them.
Time horizon – how long have you got? If you’re investing for your retirement, you may have decades to see how those riskier investments play out. If you’re saving for your children’s education, the timeline may be more compact so you might want to consider safer options.