Investing

INVESTING: What is Asset Allocation & Why Does it Matter?

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What is asset allocation and how can you use it to build a better investment portfolio?

What is Asset Allocation?

Asset allocation is best summed up by the following saying:

Don’t put all your eggs in one basket

So asset allocation is the process of allocating your money such that you don’t have all your investments in one type of asset.

What Assets Can I Invest In?

When choosing investments there are 5 broad types of assets you can purchase:

  1. Shares
  2. Property
  3. Fixed interest
  4. Cash
  5. Alternatives

Within each broad asset class there may be further sub-classes, such as for property you could have:

  • Residential property
  • Commercial property
  • Industrial property

What is the Theory Behind Asset Allocation?

Different investment assets will provide different investment returns at different times.

In the long term shares and property have tended to perform the best, whereas cash will provide the worst return over the long term.

EXTRACT: Historical Asset Class Returns (Vanguard)

Asset Allocation - Asset Class Returns

You can take a closer look at Asset Class Returns using this tool from Vanguard

Saying that, during the short term shares and property can provide volatile returns (positive return one year, negative the next), whereas cash tends to be steady.

Short Term Performance

In the chart below we can see how different assets have performed each year between 2000 and 2014.

EXTRACT: The Best & Worst Asset Class Returns (Goldman Sachs)

Asset Allocation - The Best and Worst Performing Assets

One good example of the volatility of returns was A-REITs (Australian Real Estate Investment Trusts) which returned 34.03% in 2006, but then suffered in the GFC of 2007 and 2007 to record returns of -8.41% followed by -53.99%.

If you have all your eggs in one basket, you risk volatile investment returns and maybe even a loss of your investment capital

How Can Asset Allocation Help?

We can’t predict future investment returns, so to ensure you don’t get caught holding the year’s worst performing asset class the investment industry developed asset allocation portfolios.

Asset allocation portfolios seek to match your tolerance for volatile investment returns, with an allocation of your investments between the different asset classes.

The mix of assets within your portfolio should determine the volatility and performance of your portfolio over the long term.

Example: Superannuation

You would have chosen an asset allocation portfolio for your superannuation investments:

EXTRACT: Asset Allocation Portfolio Options (Australian Super)

Asset Allocation - Australian Super

Confusing Asset Allocations

The problem in the industry however, is that no one can agree on the same asset allocation portfolios – they are all different depending on which investment house you consult.

The typical names of asset allocation portfolios include:

  • Conservative
  • Moderate
  • Balanced
  • Growth
  • High Growth

Sometimes there may be 3 different asset allocation portfolios on offer, while other times there can be many more.

So Why an Asset Allocation Model Portfolio?

Using an asset allocation model should allow you a more consistent investment return, without the fluctuations associated with having all your eggs in one basket:

EXTRACT: 10 year Asset Class Returns (ASX & Russell)

Asset Allocation - Performance

Asset allocation is like opting to smooth your investment returns; so you don’t get stuck with the performance of the best / or worst asset you opt for a mixture of assets and their returns

Do Professional Investors Use Asset Allocation?

Yes. A good example of a professional using an asset allocation model is Ray Dalio (he is the founder of Bridgewater Associates, the largest hedge fund in the world, managing over $150 billion).

Ray Dalio has developed a series of asset allocation models to invest money on behalf of his clients.

Ray Dalio’s Asset Allocation Model That You Can Use

In Tony Robbin’s book Money Master the Game, Ray Dalio disclosed an asset allocation model he terms the All Seasons Portfolio:

Essentially the model involved the following asset allocation (which you would re-balance at least annually):

Asset Allocation - All Seasons Portfolio

Over the 30 year period from 1984-2013 the portfolio provided the following return characteristics (outlined in the Tony Robbins book):

  • 9.7% annual returns
  • You would have made money 86% of the time (so only four years with negative performance)
  • Average loss of just 1.9%
  • Worst loss was -3.9%
  • Volatility was 7.6%

Not bad for a portfolio that you only have to look at once a year.

Summary

  • Asset Allocation is an investment strategy that advocates a spread of investment assets
  • Different investment assets will perform differently during the investment cycle
  • If you have all your money in one investment class you risk having a poor investment performance in a given year
  • If you mix your investment assets between different asset classes you are more likely to experience a steady investment return
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The information on this blog and website is of a general nature only. It does not take into account your individual financial situation, objectives or needs. You should consider your own financial position and requirements before making a decision. We recommend you consult a licensed financial adviser in order to assist you with this.

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