Sound asset allocation is one of the keys to driving investment returns. In a sense, asset allocation is like making wine. Just as a winemaker blends different grape varieties to achieve a certain flavour, you’ll need to combine different asset types or ‘classes’ to achieve a portfolio risk and return profile that best meets your needs.
Five key asset classes
Investments generally belong to one of five key asset classes, which have differing degrees of expected return and risk. Risk can sometimes be considered as the potential for a negative return within a particular timeframe.
The following diagram shows the risk-and-return positioning of the five major asset classes. You can see that as the expected return increases, so does the risk (or probability) that the return will not be realised.
The asset classes are:
- Cash: the safest asset class, with virtually zero short-run return volatility, but with the lowest long-run expected return. Typical investments in this class include term deposits and cash accounts.
- Fixed interest: returns are generally higher than for cash, though with greater volatility. Included in this asset class are government and corporate bonds, and fixed interest funds that invest in these securities. While the asset class is called ‘fixed interest’ it can also include securities where the interest rates vary in line with market changes in interest rates. Where the security has a fixed rate, uncertainty about returns occurs because of changing interest rates. The relationship between the direction of interest rates and the value of securities is counterintuitive. When interest rates rise, the value of fixed interest securities will fall. Conversely, falling interest rates increase the value of fixed interest securities. This unusual relationship is driven by the relativities between the rate payable on the security and market interest rates. Further, investment in corporate bonds also brings credit risk – that is, the risk that the borrower may not repay the principal you invest.
- Property: returns are generally higher than for fixed interest securities because investors get rental yields plus the opportunity for capital growth through rising property values. Risks, however, are also higher because property values can fluctuate in line with the economy and interest rates, Property is also not a particularly liquid asset. Investments can be held directly or indirectly through listed or unlisted property investment funds.
- Domestic Shares: further up the risk and return spectrum than property, this asset class gives investors exposure to Australian company shares held directly or indirectly through listed or unlisted share funds.
- International Shares: although the longer-run returns and risks are not that different from domestic shares, international shares are typically treated as a riskier asset class because investors may be taking on currency risk. But, as Australia represents about 2% of the value of world share markets, international shares provide greater diversification.
- Commodities: this class includes gold and other precious metals, iron ore, oil, or agricultural commodities such as wheat or corn. Returns are achieved when the price of the commodity increases. Prices tend to be more volatile than other asset classes.
Income Assets and Growth Assets
One way of distinguishing between asset classes is through Income and Growth. Income Assets typically derive most of their return from interest or other income generated by the asset. Growth Assets typically derive most of their return from an increase in the price or value of the asset.
Some asset classes, such as shares or property, can produce both income and growth returns.
Typically, investors with a lower risk tolerance invest mainly in income assets, and those with a high-risk tolerance (and expecting higher returns) invest mainly in growth assets. But remember that some Income Assets do involve higher levels of risk (e.g. corporate bonds) and may not suit an investor with lower risk tolerance.
Understanding your risk tolerance
Investors typically differ in their ability to deal with investment risk (i.e. the risk of losing money) depending on factors such as age, employment, financial situation, investment timeframe, and psychological risk sensitivity. As they increase their risk appetite, they also increase their expectations from the return on those investments.
Other considerations that may affect investor preference are specific knowledge/skills set and pre-existing exposure to other investments. An investor with a sound knowledge of a specific asset class may feel more comfortable in investing in these assets in their SMSF. Alternatively, an investor that owns residential or commercial property outside superannuation might prefer less exposure to property within their SMSF.
It is generally not possible to boost a portfolio’s expected return without also assuming higher short-run risk or volatility in these returns. However, given a desired level of risk, an optimum expected return can be achieved through portfolio diversification.
Another key to successful portfolio construction is diversification. Diversification can be achieved where there are different return patterns from each asset class. Or, expressed another way, where the returns are lowly or negatively correlated. Correlation refers to how the prices (or returns) of assets change relative to each other. Positive or perfect correlation means that the prices of two assets move in the same direction and by the same relative amount – while the prices of negatively correlated assets move in opposite directions.
The goal is to achieve a pool of assets where the returns from those assets are lowly or negatively correlated. This provides a better balance of risk and return and helps to avoid the extremes of negative markets. By combining asset classes in different quantities, an optimum return/risk position is derived. Ultimately, this involves testing returns and their volatilities using historical and projected data and then applying those results to construct a portfolio.
Following the global financial crisis (GFC) in 2008, relatively low and stable inflation has meant the returns from equities and bonds have tended to be negatively correlated. This is because weak economic growth tends to hurt equities but help bonds, and vice versa. This suggests a combination of the two in most cases can provide good portfolio diversification. Similarly, the correlation in returns from local and international shares in local Australian-dollar terms is lessened by the often large swings in currencies over time.
Examples of target asset allocations for some generic risk profiles are shown below. The lowest risk portfolio, described as ‘Secure’, has 100% invested in income assets and 0% invested in growth assets. The highest risk portfolio, described as ‘High Growth’, has 2% invested in income assets and 98% invested in growth assets.
These asset allocations only include the traditional asset classes and are indicative. A financial adviser or other investment professional can help you decide the target allocation that best suits your SMSF.
Source: Switzer Financial Group