Good asset allocation is the key to investment performance.
Numerous studies show that is actually the mix of investments within your self-managed superannuation fund (SMSF), rather than the individual investments, that is the key to outperformance.
But to get your asset mix right, you need first to understand your risk profile and know your long-term investment goals.
Investors can typically differ in their preference for risk and return depending on their age and psychological risk sensitivity.
Generally the older and closer to retirement an investor is, the greater the preference toward lower risk and lower return – and by consequence, asset allocations that favour cash and bonds over equities.
These investors might also display a stronger preference for income over capital returns – or dividends and interest payments they can spend today, over growth in the capital value of shares or property they own.
An investor on the verge of retirement with 100 per cent of their SMSF portfolio in highly volatile emerging market equities, for example, has probably got the wrong asset allocation, as there is a good risk that returns could fall in the short term and impinge on their ability to live off their next egg. This investor is taking too much risk given their needs.
For long-term investors, the greater risk is shortfall risk – or the risk that their long-run returns won’t be high enough to meet their goals.
Even investors with more intermediate investment time frames – such as five years – should appreciate that the volatility in five-year returns from the share market, for example, is considerably less than that of annual returns.
Indeed, it is very rare for the share market to produce a negative return over a five-year period, even when bear market downturns have intervened.
Similarly, a young worker with 40 years until retirement should care less about short-run volatility in returns, and has a greater need to ensure long run expected SMSF portfolio returns are high enough to meet their retirement goals. Their portfolio allocation should be tilted toward more growth assets such as equities over cash or bonds.
Other considerations that may affect investor preference are their specific knowledge/skills set and pre-existing exposure to other investments.
"Investors can typically differ in their preference for risk and return depending on their age and psychological risk sensitivity".
An investor with good knowledge of a certain asset class or specific investments may feel lower risk by investing more in these areas than otherwise. Similarly, an investor that already owns many residential or commercial properties – or listed company shares through executive bonus schemes – might prefer less exposure to these asset classes when setting up a new investment portfolio.
The magic of diversification
Along with blending asset classes to create portfolios that match investor needs, the other key to successful asset allocation is to exploit the benefits of diversification. As the returns from different investments – both within asset classes and between asset classes themselves – are not perfectly correlated, investors can usually achieve a better trade-off between risk and return by holding a range of investments.
Imagine two businesses, for example, with the same strong long-run expected returns from selling ice creams and heaters, respectively. The returns from selling ice cream are highly seasonal, and usually come at opposite times of the year to those from selling heaters. So an SMSF portfolio that contained both businesses could greatly reduce month-to-month volatility in returns without the need to sacrifice long-run expected performance.
In general, the holy grail of asset allocation is to find investments with high expected return, low expected return volatility, and low correlation in return to other investments within the portfolio. As with ice creams and heaters, the best investments are those with negative return correlation to other assets.
In recent years, relatively low and stable inflation has meant the returns from equities and bonds have tended to be negatively correlated. This is because weak economic growth tends to hurt equities but help bonds and visa versa. This suggests a combination of the two in most cases can provide good portfolio diversification.
Similarly, the correlation in returns from local and international shares in local Australian-dollar terms is lessened by the often large swings in currencies over time
The final stage
Having decided on the range of asset classes to be considered, SMSF portfolios can then be constructed or optimised to achieve the highest expected returns for given levels of overall portfolio risk. An example of such a range in asset allocations is provided below.
Note how exposure to riskier assets such as equities – which have higher expected long-run returns – increases as allowable portfolio risk also increases.