Investment Markets and Assets

Asset Allocation & Diversification

Asset allocation is based on the fact that in different years a different asset class is the best-performing one. It is difficult to predict which asset class will perform best in a given year. Therefore, although it is psychologically appealing to try to predict the “best” asset class, it can be quite risky if you get it wrong. Someone who “jumps” from one investment to another, according to whim, may easily end up with worse results than does someone following a consistent plan.

Diversification, which is allocating investment dollars between different asset classes that offer returns that are not perfectly correlated, generally reduces the overall risk in the portfolio in terms of variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor’s wishes in terms of amount of risk and possible returns.

To determine the most applicable asset allocation of your investment dollars requires an understanding of the following:

  • Your investment goals and time-frames
  • Your tolerance to risk or volatility
  • Your requirement for income versus capital growth
  • Expected risk and future returns of the various asset classes

Types of asset classes

Examples include:

  • Cash: bank account & term deposits
  • Bonds & fixed interest: government or corporate bonds; corporate debt, investment-grade credit; short-term or long-term bonds
  • Australian shares: public companies or private equity
  • International shares: public companies or private equity
  • Property or infrastructure: real estate or listed property/infrastructure funds
  • Natural resources: oil, coal, cotton, wheat
  • Precious metals: gold, silver, platinum
  • Alternatives: hedge funds; absolute return strategies

The above list is not exhaustive. Each of the above assets can usually be purchased directly or indirectly via managed funds or unit trusts.

The next step is to choose the most appropriate asset allocation and investment strategy for each of your goals. For example:

  • Short-term goals are likely to require your investment dollars to be invested in “low risk” assets such as cash and term deposits.
  • Long-term goals, such as superannuation, could tolerate investment in higher risk assets, such as property or shares, which have a higher risk of negative returns in the short-term but the expectation of greater returns over the longer-term.

Once you have determined your asset allocation, you then need to:

  • Determine which actual investments you will purchase.
  • Monitor your investments to ensure they are meeting your goals.
  • Re-balance your portfolio each year to ensure that the allocation of funds to each asset or asset class is realigned to your original asset allocation.

Re-balancing your portfolio generally means selling some of the assets/investments that have performed well over the year (i.e. take some of your profits) and re-invest those funds into the assets that have not performed as well. However, you will need to take into account any capital gains tax that may apply before deciding to sell any investments.

Although this approach may sound counter intuitive, research has shown that no one asset class has performed the best year in and year out.

Alternatively, if you don’t want to sell any investments and you are adding more funds over the year eg: superannuation contributions or savings plan, you could then re-direct those contributions to the lower-value assets. This will help re-balance the portfolio over time.

Ways financial advice can help:

  • Determine the most appropriate asset allocation for your investment dollars taking into account your current situation, investment goals and timeframes and your risk tolerance.
  • Recommend appropriate investments and structures.
  • Manage and re-balance your portfolio for you if you don’t have time to do it yourself.

Sofie Korac is an Authorised Representative (No. 400164) of Prudentia Financial Planning Pty Ltd, AFSL 544118 and a member of the Association of Financial Advisers.

Financial Advice Sydney and the North Shore Office based in Gordon NSW

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