The asset allocation of an investment refers to the types of investments that you – or your investment fund – owns and how it is divided up.
These are basically split into 2 categories – INCOME assets such as cash, bonds, and term deposits and GROWTH assets such as shares, property, infrastructure and commodities.
Each asset class has different characteristics and will perform differently over time.
Income assets tend to be more capital stable (less ups and downs) and produce regular income. Income assets are good for short term savings goals (1 – 5 years)
Growth assets tend to be more volatile (bigger up and down swings) and focus on long term capital growth.
Income assets tend to produce lower returns than growth assets over time.
Why does it matter?
Getting the mix right will optimise your long term investment returns and help you to meet your investment goals.
The main factors to consider when establishing an asset allocation are 1. how tolerant you are likely to be to the ups and downs of your specific investment and 2. how long the money is going to be invested for. For example, most retirement savings, like KiwiSaver, are long term investments. The definition of long term for investing is at least 7 years. If someone retires today at the age of 65, their average life expectancy is going to be 90, so they are still long term investors.
If you opt to “play it safe”, you will be leaving money on the table. If we were to look at a 2% investment return and then a 4% investment return compounded over 10 years, the difference between the 2 is not 20% but 35%! That is statistically significant.
However, if you overdo it, freak out at the first significant market downturn and take all of your money out, you are likely to be concreting in a LOSS that you will not recover, and will be scared to invest going forward.
It is true that older people generally prefer lower volatility. Retired people who are not working any longer do not have the ability to invest more money if markets get tough, and this is an influence on their decision making. Younger working people have the ability to save more and therefore should be prepared to take on a bit more investment volatility.
Having a MIX of investments also reduces the volatility of an investment portfolio as different investments perform in different ways at different times. It is also not a sound strategy to have all of your eggs in the same basket. If your portfolio is 100% term deposits, you are going to have significant volatility in terms of returns as interest rates move. The same will apply if you are 100% NZ shares. Having a mix of different investments reduces the overall volatility significantly.
Your asset allocation determines your investment results. This is why it is important to consider what asset allocation strategy you would like before you start to invest. Once you have decided on an asset allocation, the next step is to STICK WITH IT to reap the rewards of your decision.
Janet Natta is a financial adviser and director of Smart Money Advice, offering investment portfolio construction and management services to clients throughout NZ, as well as comprehensive financial planning advice to assist clients to build and protect wealth to achieve their dreams.
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