How do I get the right mix of assets in my portfolio?
This principal - that you should put your wealth into multiple investments instead of just one - is called “diversification” and is one of the core tenets of prudent investment.
But how do you choose what types of investment to put your money into? Do you just pick a number of promising investments at random, or is there more to it?
The strategic placement of your money into different types – or “classes” of investments is called “asset allocation” and is something you need to consider to achieve a properly diversified portfolio.
Asset allocation is the spread of your investments across asset classes.
The goal is to allocate your investments among these different classes in a way that reduces your risk and market volatility without reducing your returns.
Ideally, the return on the assets should be negatively correlated, so when one falls in value, the other increases.
If you get it right, losses in one investment may be wholly or partially offset by gains in another.
About asset classes
Investments can be divided into four main asset classes:
- Cash (money in the bank or a term deposit)
- Fixed Income (bonds or RMBS)
- Property (Real Estate Investment Trusts or direct property)
- Shares (companies listed on the ASX or Exchange Traded Funds).
For the purpose of asset allocation, these four asset classes can be separated into two broad groups: Defensive and Growth investments.
Cash and Fixed Income such as bonds are “defensive” investments which aim to provide steady income with capital stability. These assets are less likely to lose money, and returns on the investment will be lower over the long term.
One example of a defensive bond investment which yields regular income and is accessible to ordinary investors is the (High Livez) fund, managed by Firstmac.
High Livez is a bond fund backed by Australian home loans. It invests in Residential Mortgage-backed Securities, a type of bond that is secured by a pool of residential mortgages. The RMBS are issued by leading financial institutions including the Big 4, credit unions and non-bank financial institutions.
All investments carry an element of risk, but High Livez is considered relatively low risk and defensive compared to something like stocks.
The main assets considered to be “growth” investments are property and shares. These can provide variable income as well as potentially increasing in value over time.
Growth assets have higher expected returns in the long-term, but the risks of losing money are higher, especially over short periods.
How much to put in defensive and growth assets?
The starting point for Asset Allocation decisions is in determining what proportion of a portfolio should be allocated to defensive assets and what proportion should be allocated to growth assets.
The correct asset allocation between defensive and growth assets depends very much on your personal circumstances, risk tolerance and goals. There really is no-one size fits all answer.
One common approach is to assume that the sooner you will need your money, the lower your risk tolerance should be, and the higher your allocation towards defensive assets such as cash and bonds.
Many investors believe you should invest more of your wealth in growth-oriented investments like shares when you’re younger. But as you approach retirement age, you should gradually cut down on your exposure to equities and move toward fixed-income investments.
This is summarised simply in the “100 Rule”. This argues that you should take the number 100 and subtract your age. The result should be the percentage of your portfolio that you devote to shares. If you're 30, this rule suggests you should invest 70% of your money in stocks. And if you're 70, you should invest only 30% in stocks.
So there you have it. That is a basic introduction to how asset allocation works. To get an allocation that is appropriate for your needs, be sure to get independent financial advice.