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This article appeared in the August 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Asset allocation begins with knowing your investment needs.

Photo of Toni Case By Toni Case, The Bull

Truth be told, most of us want double-digit returns on our investments each year and we don't ever want to lose money. In a naive way, many try to achieve this by randomly choosing fast-moving shares, blindly following trends and generally taking on too much risk. When we don't earn double-digit returns we are disappointed; when we lose money we are mortified.

People do not build houses by randomly plonking bricks next to each other. Houses are carefully built on architectural plans that determine such things as floor layout and the relationship between rooms, walls and doors. Similarly, professionals construct investment portfolios using a plan that takes into consideration important features such as an individual's age, attitude to risk, investment timeframe, existing assets, income, tax rate, investment goals and so on. As the well-worn saying goes, "if you fail to plan, you plan to fail".

The investment horizon

Your investment plan must be specific to your goals and personality, as well as your investment timeframe. Just as an architect does not design the same house for a family of six as for a childless professional couple, a 35-year old should not have the same investment strategy as a 65-year old; and someone planning to start full-time study next year will have a different investment strategy to someone planning to work full-time for the next 20 years.

You need to determine the time available to build your assets. If you intend to work full-time until retirement, how many years away is that? Perhaps you would like to set up your own business one day and need to save for start-up costs. When will you need to turn your investments into cash?

Attitude to risk

Most investors mistakenly believe they are risk takers. It is common for people to choose the "high growth" category for superannuation, when in reality a 20 per cent fall in their investments, sending the portfolio from $100,000 to $80,000 or lower, would cause considerable stress. High-risk investors are those who can handle a 20 per cent fall without raising a sweat.

As mentioned, risk tolerance is also tied to the following:

  • Investment timeframe - when will you need to convert your investments into cash?
  • Your age - do you intend to work full-time for the foreseeable future, or will you be retiring soon?
  • Your goals - is wealth accumulation important to you? Do you prefer a set-and-forget investment strategy?

Risk tolerance is also linked to existing assets and debt. If you are already geared to the hilt on a property purchase, taking on more risk across your remaining portfolio may take you way above your tolerance level.

Asset allocation

The reason for thinking through the above points first is that they are prerequisites for step two: investment selection. Most people head directly to the sharemarket for answers - weighing up whether BHP is a better bet than NAB.

Instead, first consider the range of asset classes available, which include domestic and international shares, direct and listed property, fixed interest, and cash. And depending upon your risk profile, you should ideally allocate a percentage of money across each of these asset classes.

Below are examples from Securitor of four different portfolios ranging from high risk to conservative, with some telling statistics that highlight the upside and downside of taking on extra risk. These examples are for illustrative purposes only.

High growth - for a timeframe of 10 years and over

 Property  6%
Australian cash 0%
Australian fixed interest 0%
International fixed interest 0%
Australian shares 45%
International shares 49%

Source: Securitor

The high-growth portfolio invests entirely in shares and property in an effort to maximise returns. The portfolio could potentially make percentage returns in the high 30s in a bumper year, or tumble by as much as 14 per cent in a market downturn.

Growth portfolio - for a timeframe of seven years and over

 Property  9%
Australian cash 3%
Australian fixed interest 7%
International fixed interest 8%
Australian shares 37%
International shares 36%

This growth portfolio has an 82 per cent allocation to shares and property, but spares 18 per cent of its money for cash and fixed interest. Because of its high allocation to growth assets, this portfolio could make as much as 30 per cent in a bull market but could also tumble by as much as 10 per cent in a downturn.

Balanced portfolio - for a timeframe of five years and over

 Property  9%
Australian cash 7%
Australian fixed interest 14%
International fixed interest 11%
Australian shares 31%
International shares 28%

Moving down the risk spectrum, the balanced portfolio has a 68 per cent allocation to shares and property, and a 32 per cent allocation to fixed interest and cash. Because of its profile of lower risk, the returns are unlikely to ever exceed 30 per cent (the best you could get is around 25 per cent), but you are compensated by the security of knowing the portfolio should not lose more than 7 per cent in a downturn.

Moderate portfolio - for a timeframe of four years and over

 Property  8%
Australian cash 10%
Australian fixed interest 23%
International fixed interest 19%
Australian shares 22%
International shares 18%

Further down the risk spectrum is the moderate portfolio. These investors face a much smaller 6 per cent chance of losing money, which would only affect the portfolio by about 3 per cent on average (taking six months to make it back). But the portfolio's returns are less exciting - forecast between -3 per cent and +19 per cent in any given year.

Defensive portfolio - for a timeframe of three years and above

 Property  7%
Australian cash 25%
Australian fixed interest 25%
International fixed interest 20%
Australian shares 13%
International shares 10%

The defensive portfolio is less likely to lose money in any given year. But investors trade off this security with lower returns, which could rarely exceed 14 per cent even in a cracking year.

The above exercise is a handy way to ascertain your preference for security, set against high returns. Some will be tempted by the chance to receive 30 per cent or more, even against the backdrop of possibly losing 14 per cent of their savings in any one year.

Others will be completely turned off by the thought of losing money, regardless of the returns that could be made.

Monitoring your asset allocation

Having determined which asset allocation you believe best suits you, unfortunately it is not a matter of simply dividing your capital between the asset classes and that's that. As markets boom and stagnate, asset allocations will move accordingly. For instance, after a bull market in equities, the allocation to equities will be much higher than bonds. So if you want to retain the same risk level it is advisable to realign your portfolio every three years or so by selling down overweighted assets.

Other factors that change over time are your investment goals and risk tolerance. As you become more educated about investing and the sharemarket, you may want to lift your weighting towards shares to accommodate more risk.

About the author

Toni Case is the editor of Each week TheBull's free newsletter offers 18 share tips from more than a dozen leading brokers, tailored share portfolios for income and capital growth, plus investing, super and property strategies.

From ASX

For another perspective on asset allocation, using ASX Listed products, read 'Five Star Super Strategies', which appeared in the June 2011 ASX Investor Update.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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