Diversification, Asset Classes, Strategic Asset Allocation versus Dynamic Asset Allocation, Risk Profile, Market Correlation, Volatility. What do all these terms mean and more importantly, what do they mean for you, the investor?
Many of you will have had the conversation with us at some time about “Asset Classes” or “Asset Allocation” and your “Risk Profile”, you may remember only a little, or a lot, but let’s summarise the fundamentals to set the stage. Some of our earliest client conversations revolve around getting an understanding of your tolerance for risk, sometimes referred to as the ‘sleep at night’ factor. Are you the type of investor who doesn’t worry too much about the ups and downs of their investments; or do the daily, weekly, monthly swings of your account keep you up at night?
This is a mindset that not only is different from person to person, but that changes over time with investing experience, personal circumstances and the purpose of the investments. Your tolerance and preferences around taking investment risk helps determine your “Risk Profile”, though we also take into account other factors of your circumstances.
What do we do with this Risk Profile? Well, this guides us to the “maximum” risk you can take emotionally and intellectually with your investments. You may not need to invest at this maximum level, but we won’t go “more risky” without discussion and a strong reason. How do we determine the “risk” of your portfolio? We use calculations for short and long term “Volatility” of different mixes of investments as a guide.
You have probably seen the pie charts of a typical investment portfolio, whether in our Statements of Advice, a superannuation statement or some other material about diversified investing. They illustrate that your pool of investments (whether in super or elsewhere) is made up of different “Asset Classes” and what percentage that is in each Asset Class determines how volatile the portfolio overall will be over time.
A quick recap on Asset Classes
An asset class is simply the name we give to different groups of investment types. Generally we refer to Shares (or Equities), Property, Bonds and Cash as asset classes, but these can sometimes be grouped or split depending on the detail desired.
For example; Shares are often broken into Australian Shares and International Shares, and the same for Bonds. Similarly; Cash, Bonds and Hybrid Securities are often grouped as Income, and Shares and Property can be called Growth assets.
For the purposes of our advice we usually define asset classes as follows:
- Australian Fixed Interest (or Income Securities)
- International Fixed Interest (or Income Securities)
- Australian Shares (or Equities)
- International Shares (or Equities)
The first three are generalised as defensive assets and the second three growth. Alternatives do not fall neatly into defensive or growth categories so they stay alternative.
Asset Allocation is the decision of how much of each Asset Class should be invested in a given portfolio. This is an important decision because this affects not only the long term investment return you can expect, but also the volatility of the portfolio over time.
How much does it matter? It turns out a lot; research studies have estimated that over 85% of the return you receive is related to the Asset Allocation decision compared to underlying investment choices. What does that mean? It means your decision on whether to hold 20% or 40% of your portfolio in Australian shares is much more influential on whether you got 5% or a 10% return on your super fund than whether your Australian Shares fund manager did or did not beat the rest of the market.
Your Risk Profile and how it influences your Asset Allocation choices changes your returns.
Strategic versus Dynamic
Your Risk Profile (and other external factors) help us choose the “right” Asset Allocation for your investments. The mix of how much Growth or Income (or Alternatives, which we will discuss in a future article) and the underlying proportions are chosen based typically on how these assets have behaved historically.
Based on historical averages, a Growth portfolio may look something like this:
A Conservative profile may look like this:
These give us a neutral starting point, or a “Strategic” Asset Allocation. History suggests that a Conservative investor will want less Shares and more Income Securities than a Growth investor. However, “Dynamic” Asset Allocation recognises that historical averages aren’t great guides to the future, even the long term future averaged over 10 years or more.
By attempting to calculate future asset class behaviour, we can tilt or move our Neutral Asset Allocation over time to get a better outcome, whilst also staying “Conservative” or “Aggressive” investors. This pro-active Dynamic Asset Allocation has been shown to be highly effective when considering over or under valued markets, based on expected future returns, not historical averages.
This strategy aims to avoid bubbles and other market extremes and protects capital ahead of ‘chasing returns’, without reducing returns or increasing volatility.
The chart below shows what an actual portfolio looks like over time under Dynamic Asset Allocation. You can see the strong changes happening only gradually to take advantage of, or avoid, market extremes.
This contrasts with the more traditional Strategic Asset Allocation that rides out the extreme market movements without trying to adapt.
The regular rebalancing after small market movements accounts for the relatively steady percentages.
Does it matter?
Yes, over time Dynamic Asset Allocation has shown to improve long term returns whilst reducing the severity of losses (smoothing volatility).
If you would like to discuss how the concepts and strategies in this article might apply to your personal situation, please contact us.