Investment Fundamentals

Asset Allocation

Setting your asset allocation

Background

Asset allocation refers to the amounts within an SMSF investor’s portfolio that are allocated to specific types of investments.  Asset allocation provides investors with the ability to balance risk and reward, by allocating a portfolio’s investments according to their age, investment horizon, goals, and risk tolerance, using a multi-layered diversified approach. It effectively ties together all of those things we have discussed in the previous articles in this series.

Why is asset allocation important

Asset Allocation is arguably the most important part of the investment process, as it will generally have the greatest impact on the overall risk and return characteristics of the portfolio. It has been estimated in the past that up to 80% of an investment portfolio’s return (and volatility) over time can be attributed to its asset allocation, rather than individual investment selection.

Therefore, before researching and selecting individual investments, an SMSF investor should take the time to set a strategic asset allocation for their fund, based on their goals, time horizon, and risk tolerance.

How it works in practise

Creating an asset allocation for an SMSF does not have to be a time consuming, painful process. In fact, it can done is a relatively stress free way by focusing in on these 3 key issues:

  • What is the goal, and what is the time horizon?
  • What is the risk tolerance of the investor?
  • Is a multi-layered, diversified investment approach to be used?

Probably the best way to illustrate how this 3 step process can be used, is to illustrate 3 typical SMSF asset allocation examples. We will assume each is a two member fund.

Example 1: The Growth Investor

Our first SMSF has the following details:

  • The members are in their mid 40’s, working good stable jobs, and contributing around $10,000 per annum each ($20,000 pa combined) into the fund.
  • Their key goal is to grow their SMSF account balances as much as possible over the coming 20 years.
  • They have a high risk tolerance, given they are both fairly comfortable with volatility and have a long term attitude to investing.
  • Diversification is to be used both across asset classes, and within asset classes.

Result:
In this example, a “Growth” asset allocation of approx. 80% growth assets, and 20% defensive assets could be appropriate.

Justification:
This high allocation to growth assets such as shares will give them the best chance to achieve their goals over the long term. The negative aspect of this (being the higher risk and volatility) is ameliorated by the fact that they have a lot of time to ride the ups and downs of markets, and they are emotionally comfortable with it. Further to this, diversification will be used extensively in growth assets across both domestic and global shares, and property trusts, and across both small cap and large cap shares, with no single direct share holding being any more than 4% of the portfolio.

Example 2: The Balanced Investor

Our second SMSF has the following details:

  • The members are in their mid to late 50’s, one working full time, one part time, and contributing around $15,000 pa combined into the fund.
  • Their key goal is to grow their SMSF account balances as much as possible over the coming 5 to 7 years when they are thinking of retiring.
  • They have a mid level risk tolerance. They are both fairly comfortable with volatility however they are conscious of not taking too many big hits to their capital as their time in the workforce is into its final 5 to 7 years.

Result:
In this example, a “Balanced” asset allocation of approx. 60% growth assets, and 40% defensive assets could be appropriate.

Justification:
This more balanced allocation to growth and defensive assets will give them a good chance to achieve their goals over the long term, whilst the higher risk and volatility of growth assets is ameliorated by the allocation to defensive assets. They still have a reasonable amount of time to ride the ups and downs of market cycles, and they are emotionally comfortable with it. Further to this, diversification will be used extensively in growth assets across both domestic and global shares, and property trusts, and across both small cap and large cap shares, with no single direct share holding being any more than 3% of the portfolio. Further to this, diversification will be used extensively in growth assets across both domestic and global shares, and property trusts, and across both small cap and large cap shares, with no single direct share holding being any more than 4% of the portfolio.

Example 3: The Conservative Investor

Our third SMSF has the following details:

  • The members are in their mid to late 60’s, and fully retired from the workforce.
  • Their key goals are to fund an income stream from their SMSF account balances over the next 20+ years, equal to 4% of their capital.
  • They have a low risk tolerance. They can accept a bit of volatility however they are conscious of not losing capital to fund their retirement.

Result:
In this example, a “Conservative” asset allocation of approx. 30 to 40% growth assets, and 60 to 70% defensive assets could be appropriate. However, ideally a specific portfolio construction methodology will be used to create the required income, capital growth, and risk control.

Justification:
In this era of ultra-low interest rates, they will require an allocation to equities to create the income level required, plus the capital growth to keep up with inflation, however there are enough fixed interest investments to ensure volatility is dampened sufficiently. Diversification across asset classes and within asset classes can ensure there are multiple sources of income and no one investment risk can negatively affect the portfolio.

Summary

Whilst we have created three examples above, there are many many others. Creating your asset allocation will still follow these steps.

Clearly identify your goals and the time frame involved, understand your risk tolerance, and create your asset allocation to fit these with enough diversification to ensure no one investment will put a major hole in your portfolio.

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