In the same way that finding a balanced lifestyle is conducive to good health, finding balance in an investment portfolio gives investors the healthiest chance of achieving their long-term goals.
Having a diversified mix of assets is essential because it can potentially mitigate market volatility and reduce portfolio risk. This is because the best-performing asset one year can be the worst-performing the next.
Consider cash. In FY22, a year marked by economic uncertainty and geopolitical conflicts, cash topped the list as generating the best returns at 0.1 per cent, according to Vanguard research. The last time cash was king however was more than 10 years ago during the Global Financial Crisis.
Conversely, the worst performing asset in FY22 was Australian listed property returning -12.3 per cent, according to Vanguard research on asset classes. A year before, it was amongst the best performing asset classes with 33.2 per cent.
What’s clear from these returns is that markets are impossible to predict; past performance does not guarantee future performance. So, one of the best things investors can do to lessen this ambiguity is simply to diversify.
[Editor’s Note: Diversification is an important aspect of constructing and monitoring portfolios. However, diversification is no guarantee of avoiding negative portfolio returns. During periods of high market volatility, the price of most assets can sometimes fall. Building a balanced portfolio across asset classes is also important, but such a portfolio might not suit all investors. An investor in retirement will require a different asset mix in their portfolio compared to a younger, growth-focussed investor. Do further research of your own or talk to a licensed financial adviser before relying on themes in this article].
What does it mean to be diversified? A good place to start is to understand what it is not: that the more investments you own, the better diversified you are.
Investing in several shares from similar industries may reduce single-company risk, but it may not sufficiently protect you from sector downturns, nor does it let you capitalise on potentially stronger performance elsewhere.
Different asset classes have different risk/return characteristics and, as evidenced in the cash-property example earlier, generate different rates of return in any given year.
Generally, shares and bonds move in different directions. During periods of equity market downturns for example, high-quality investment-grade bonds tend to act as a buffer to volatility and can potentially cushion any dramatic falls in portfolio value.
Similarly, investing only locally or in one region also carries limitations. Politics, industries, and consumer sentiment vary widely by country, generating different rates of economic growth. Not investing internationally may cause investors to miss opportunities to temper domestic market swings, given that global economies do not grow or contract in sync.
Broadly speaking, there are three risk/return profiles on which investors can choose to build a portfolio:
Which allocation is best depends on an investor’s goals, time frame and age.
A conservative portfolio generally allocates the majority of money to less risky assets such as bonds, whereas a growth portfolio will preference equities.
Generally, the longer your investment horizon, the more risk you can take as short-term volatility tends to smooth out in the long run; day-to-day market fluctuations therefore have little impact over the long run.
An example of a balanced portfolio could consist of 50 per cent growth assets such as Australian shares, international shares and emerging markets, and 50 per cent income assets such as Australian fixed interest, international fixed income and cash.
The combination of assets that investors choose to include in their portfolio – known as their asset allocation – is one of the key determinants of investment returns and explains the majority of portfolio variability over time. Market timing and stock selection on the other hand tend to have little impact on long-term performance.
This is why sticking to the right asset allocation through periodic portfolio rebalancing, as life goals evolve and markets fluctuate, is important.
Say you’ve selected a balanced approach and for simplicity’s sake, are targeting a 50/50 split between shares and bonds.
You originally invest $1000 in a shares fund which buys you 20 units. You invest another $1000 in a bond fund, which similarly buys you 20 units.
Fast forward a few months and assume shares have performed strongly while bonds have been flat.
This in turn means that the asset allocation is getting out of balance, away from your desired 50/50 split. From a return perspective, this might seem positive but the market risk within the portfolio has edged higher than desirable for a balanced investor. This means you are now overweight in shares and taking on more risk than you may have first anticipated.
Rebalancing the portfolio back to the 50/50 allocation is the logical remedy but many investors struggle to do it because it can seem counterintuitive to sell a well-performing asset to buy more of the under-performing asset. But keep in mind rebalancing is about managing risk and not maximising returns.
There’s no way of predicting if shares will continue to outperform or if they’ll tumble tomorrow – if they do, you might be losing more than you are comfortable with.
An alternative to building your own portfolio is to invest in diversified funds or Exchange Traded Funds (ETFs) – akin to a ready-made investment portfolio aimed at providing long-term returns that match an investor’s desired level of risk.
Not only, as the name suggests, do diversified funds and ETFs have in-built diversification across multiple asset classes and markets, they also reduce the transaction costs associated with investing in different assets as you simply invest in just one.
As these funds and ETFs are professionally managed, investors also benefit from the investment expertise and automatic periodic rebalancing.