Begin To Invest 4 – Asset Allocation

Assets. The fun part of the net worth equation, indicating what you own.

Net Worth = Assets (yay!) – Debts (boo!)

When it comes to investing, deciding which assets to buy has an impact on the “safety” and performance of your portfolio. No single type of asset is guaranteed to be safe—even cash under the mattress could be stolen. However, some assets are less risky (cash in the bank) than others (hello Bitcoin!). As discussed previously, there is generally a link between risk and reward. The higher the risk, the higher the return. Choosing which assets to buy, in what combination, can help you to manage risk and hopefully maximise your returns.

Why Choose More Than One Asset?

Imagine you loved photography back in the 80s. (I know, some of you weren’t even born then. From the other side, it’s pretty daggy, but it was a great decade. Stick with me here.) You loved it so much you decided to put all your investment money ($1,000) into buying shares in Kodak. They made the cameras, they made the film, and they were a market leader. Then along came a disruptor—digital photography. On 3rd September 2013, right before they went bankrupt, your $1,000 was worth $0.64. That’s right, only 64 cents. This is what happened to your investment:

Kodak Share Price Graph 1980 - 2013
It was a slow drop, but severe.

Now imagine that you loved photography, but you decided to hedge your bets and jump on this new technology. You put half of your money into Kodak, and the other half into Canon. On the same date as above, your investment would instead be worth $13,800. Not bad at all.

Canon Share Price Graph 1980 - 2017
Woohoo! Look at that growth! There’s Kodak way down on the bottom blue line.

Finally, what if Kodak was only one of 10 related companies you had invested in? Your portfolio would be worth $6,764.

Companies Related to Kodak Share Price Graph 1980 - 2017

Now, I haven’t done any sophisticated calculations regarding dividends, stock splits or inflation, and obviously many of these companies weren’t around in 1980. But returns vary from +3381% to -99.93%. While you won’t receive as large a return as if you’d invested purely in Canon, you also haven’t run the risk that Canon tanked like Kodak, leaving you with nothing.

And all the examples above? They relate to the same industry. It is possible that a whole industry can die (car manufacturing in Australia), so to further spread your risk, you invest across industries, or products, or services.

The moral of the story is that to reduce risk, you need to choose a mix of investments. What’s available? Let’s explore the different basic types of investment assets, remembering that the definition of investing is…

Definition of Investing from Investopedia.com

Asset Classes

Investment assets are broken into different types, called classes. The four most common traditional types of assets for investing in Australia are:

  • Shares
  • Property
  • Bonds
  • Cash

Each of these has a general risk level, moving from the highest risk with shares, to the lowest risk in cash.

Beyond the four staples, there are other investment classes, but heed my warning! Sometimes these may border more on gambling than investment. You have to know your stuff inside out before even considering investing. These are by far the riskiest types of investment.

A list of unusual investments.
Weather and Catastrophes. Seriously.

Reducing Risk

Rather than investing in a single share, like Kodak above, it’s possible to reduce risk by diversifying either within or across asset classes. Investing across asset classes means having some shares and/or some property and/or some bonds and/or some cash in some combination. The mix of these you buy will depend on your risk tolerance, and what you are comfortable with. I know I don’t want to be a landlord, so I don’t have property in my portfolio.

A rule of thumb is to hold 100-your age in shares, the rest in bonds. So following this rule, I would split my investment into 100-45 = 55% shares, 45% bonds. This rule has been brought into question due to our lengthening lifespans and market conditions. Some are suggesting a better calculation may be 110 or 120-your age, especially for those just beginning in the workforce. However, if you are looking for somewhere to start, this might be a simple way to do it.

Let’s look at how you can diversify within asset classes.

Property Diversification Factors

Type: When I think of investing in property, I think of residential property. That’s what always makes the news, and it’s the type of property we are most familiar with. Yet it is possible to invest in commercial, industrial or retail property. It’s also possible to invest in property without ever getting a loan and buying one, by using Real Estate Investment Trusts, or REITs. These allow you to invest in diversified property types, including markets you couldn’t afford, for a much smaller investment than entering the residential property market.

Location: If you were looking to manage an investment property yourself, it would probably need to be close(ish) to where you live. Over the past 18 months, if you lived in Perth, you would have watched your property value drop. However if you owned a property in Canberra as well, then great! The gains of one are balancing the losses of the other.

State of the Market Report Graph

Share Diversification Factors

If buying individual shares, you need to think about whether they correlate. That is, are they likely to be affected by the same factors, and rise or drop together? A mining company and a transport company may not appear to be correlated. However, if the primary purpose of the transport company is to supply huge mining trucks, then when the mining industry falls, it is likely the transport company will also fall. Alternatively, perhaps when the mining industry falls, the renewable energy industry might be growing. That is an example of non-correlated assets.

Type: Growth, Value or Income. Growth shares are companies that seem to have a lot of growing to do, so they tend to reinvest most or all their capital into growth or expansion. You are hoping the share price will rise over time, but you aren’t likely to be getting any income along the way. Income shares provide income to investors in the form of dividends. You hope that the underlying price is also increasing so you experience growth, but that is not the primary reason to purchase. Sometimes, for a multitude of reasons, shares in a company may be trading at a price below their true value. These are value shares. It’s like buying an item on sale, then hoping you see it full price again next week, so you know you got a bargain. Of course, nothing is guaranteed.

Market Size: This is known as capitalisation, and is calculated by multiplying the number of shares the company is broken into, by its share price. This gives a better picture of the true value of a company than share price alone. A company with a share price of $100 might at first glance look to be bigger than one with a share price of $1, but if the first only had 100 shares for a total market capitalisation of $10,000, and the second 1,000,000 shares, the value of the second is far greater than the first.

Generally companies are described as small, medium or large cap, and each has its own level of risk. Large cap companies have probably been around for some time, so may be seen as more stable and less risky than a small cap company. Small caps might be new, or cutting edge and provide potential for explosive growth.

Industry/Sector: The ASX operates under the Global Industry Classification Standard, which “consists of 10 Sectors aggregated from 24 Industry Groups, 67 Industries, and 147 Sub-Industries currently covering over 27,000 companies globally.” While this quote comes directly from the ASX, they display 13 different GICS sectors. Does it really matter? Not for this article! The point is that you have a lot of choice to help spread risk within the asset class of shares.

ASX GICS Sectors
ASX GICS Sectors

Market Maturity: Developed, Emerging or Frontier. Australia is one of 24 world markets classified as a developed market. These all have a high level of economic stability, good infrastructure, developed manufacturing and services, and relatively high wages. MCSI currently classifies 25 countries as emerging marketsthose with less developed economies that are going through a period of rapid growth, and 22 as frontier.  Countries in the frontier market categorisation are a subset of emerging markets, with a lower standard of living, being marginally developed. As a general rule, developed markets are the least risky, while frontier markets are the most risky.

Geography: Domestic or Foreign. It is possible to only buy Australian shares. You are probably more familiar with the companies, and Australian shares have the option to pay franking credits, reducing your tax. However, look at the amazing infographic at the end of this post. The Australian sharemarket only makes up 1.75% of all the world markets. It is entirely possible for a country’s entire economic system to crash (Greece, 2015) with their sharemarkets following suit, so mixing it up can help lower your risk.

Bond Diversification Factors

Type: Governments generally issue bonds, yet it is possible to buy corporate bonds issued by companies. These are different to shares, because you are lending money to the business, not buying a part of the business. Corporate bonds are seen as safer than shares, but riskier than government bonds. There is a possibility the business may stop trading, and you will not regain your money.

Time: Long-term or Short-term. Long-term bonds generally pay a higher interest rate, because they carry a greater risk that the price will fall due to rising interest rates, or the value will drop because of inflation.

Cash Diversification Factors

Type: Cash can be kept in a regular bank account, a high-yield savings account, or under the bed (not recommended).

The Perfect Asset Allocation

There is no perfect asset allocation. As Pete Mathew says, if there was a perfect asset allocation and everyone chose it, there wouldn’t be a sharemarket and nobody would make any money! What you choose to invest in should be determined by your risk tolerance, which is likely to change over your life. There are rules of thumb to help you as a starting point. These will differ slightly depending on where you look, but to give you a rough idea:

  • Conservative/Cautious = 20% shares, 80% bonds
  • Moderately Conservative = 40% shares, 60% bonds
  • Balanced = 50% shares, 50% bonds
  • Growth/Moderately Aggressive = 60% shares, 40% bonds
  • High Growth/Aggressive = 80% shares, 20% bonds

So Mrs. ETT, How Did You Choose Yours?

I didn’t! I suffer from paralysis by analysis. Give me more than 3 choices and I’m likely to throw my hands in the air and give up all together. Instead, I identified our risk profile, then let the experts at Vanguard do it for me, by investing in their Vanguard LifeStrategy® High Growth Fund. The asset allocation looks like this:

Asset Allocation of Our Vanguard Portfolio.

I also have small amounts in peer-to-peer lending with Ratesetter, Acorns, and cash in a high interest savings account. I still feel the pull towards property, but I know I don’t want to put the work into being a landlord, so I may look into REITs, or a property trust in the next couple of years.

If you wanted a bit more control (and lower fees), you might look into the type of investing that AussieFIREbug does. Instead of a managed fund, he buys a combination of three ETFs from Vanguard, as well as owning property. Jump across using the link above, where he goes into further detail.

Owning a range of assets that allow you to meet your risk profile is essential. If you would like to choose your assets one by one and build up your own asset allocation, then go for it. But if it all seems too much, don’t let that stop you. Begin by letting the experts (such as Vanguard or Acorns) do it for you. There will be fees because you are paying for their knowledge and effort, but as long as you make sure they are minimal, you will be on the way to investing in no time!

Do you manage your own asset allocation? What influences your choice?

Courtesy of: The Money Project

2 thoughts on “Begin To Invest 4 – Asset Allocation

  1. Wow – so much detail. I love all the graphs and colour, it helped to keep my interest longer for sure. I don’t know why but I’m a bad personal finance blogger and for some reason glaze over at detailed talk of such things…I definitely like a simple set and forget approach and only get interested in current affairs when I can see my share prices fluctuate I want to know why.

    Anyway enough rambling from me, I’m sure many others will find this post very interesting and informative 🙂

    • Oh, I do know what you mean. I’ve got a couple of blog posts that I haven’t read yet because every time I open them I think… ‘not right now’. I know they are good for me, and I really want to read them, but I have to be in a thinking frame of mind.

      This one was written to help me get a better understanding of what I could look at if I ever want to step away from the easy approach.

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