“The appropriate asset allocation depends on the individual investor’s time horizon, financial goals and risk tolerance.”
The main fundamental portfolio asset classes are cash, equities, bonds and real estate.
How do you allocate your portfolio across asset classes?
First, consider the investment returns of the different classes – they vary under different market conditions. Investing in more than one asset class will reduce the risk of loss and portfolio returns will have a ‘smoother ride’. Statistically we would say the returns have a smaller standard deviation. If the returns of one asset class in your portfolio falls it should be possible to counteract your lower returns or losses in that class with better or steadier investment returns in another.
Protection against inflation also varies by asset class, as do tax considerations. Although consumer price inflation in Australia is currently low, principal will still lose its purchasing power over time due to the compounding of CPI inflation unless after-tax returns exceed inflation. In general tax considerations should be secondary to the underlying risk return features of the investment. Investors should seek tailored personal advice on their tax position.
The appropriate asset allocation depends on the individual investor’s time horizon, financial goals and risk tolerance. There are important trade-offs between the goals investors have in each respect and the investor’s level of sophistication also informs the appropriate allocation.
For example, investors who cannot afford to lose any money should invest surplus funds only in bank accounts and term deposits. Investors with strong sharemarket investing skills and a time horizon for positive returns of at least five years can consider a substantial weighting to equities, especially if they are not close to retirement and have sufficient time to earn back any permanent losses. Many investors in retirement maintain a high weighting to equities because they have a large capital gains tax liability accumulated in long-term shareholdings and a sufficiently comfortable overall financial position to be able to tolerate share portfolio volatility. Typical features of this fortunate position are full home ownership and a high ratio of dividend income to living expenses.
The following table summarises the capital loss, inflation protection, price volatility and return characteristics of the four fundamental asset classes. The ratings are high-level generalisations which abstract from the potential for ratings of individual securities or assets within each class to vary.
A little-understood asset allocation risk is the investor does not understand an asset class well enough to protect principal invested in that class. In general people should invest only in what they know regardless of the temptation to attempt to boost returns by straying into a new class unknown to them.
|Asset Class||Price Volatility||Risk of permanent capital loss||Potential protection against inflation||Potential investment returns|
|Cash including term deposits||Nil||Nil||Nil||Low|
|Fixed Interest Securities||Medium||Medium||Low||Medium|
|Property||High - but apparently and deceptively low as property prices are not quoted often||HIgh||Good||High|
For example, many Australians make good money investing in residential property but avoid shares because they know they do not understand companies and are uncomfortable with share price volatility. The editor of this article is in the opposite camp: completely comfortable with equities but inexperienced at property!
Many investors become increasingly competent at and comfortable with share market investing as they approach retirement and afterwards, and the following discussion is for them.
“A little-understood asset allocation risk is the investor does not understand an asset class well enough to protect principal invested in that class. In general people should invest only in what they know…”
Read more about Value Investing | Portfolio Diversification & Risk Management