Whether intentional or not, every investor makes asset allocation decisions.
A portfolio 100% in cash is an asset allocation decision. There is no doubt asset allocation decisions need to be made, otherwise financial goals are unlikely to be met. Most importantly, effort is required to ensure the investment array is appropriate for each individual’s circumstances.
We believe the best way for investors to achieve their financial goals is through actively-managed, long-term investment in a diverse array of attractively valued higher-quality assets, implemented at low cost predominantly via transparent and tax-effective direct securities and exchange traded funds (ETFs).
Here we discuss how wisely-constructed multi-asset portfolios mitigate risks and smooth returns for investors, and we analyse the attributes of each key asset class.
CHART 1: BENEFITS OF MULTI-ASSET INVESTING WITH ASSUREINVEST
Well-constructed multi-asset portfolios mitigate risks for investors, the equivalent of not putting all your eggs in one basket. Diversification is one of the keys to protecting capital along with focusing on high-quality assets and allowing a margin of safety before making buy and sell decisions. While we would love to have perfect foresight, that of course is not possible. AssureInvest utilises various proprietary methods for estimating longer-term asset class returns – cash, stocks, property, fixed interest – but there will always be a certain degree of uncertainty around these. Distributing assets in line with our strategies is a smart way to generate long-term upside while protecting against ruinous loss.
Diversification helps smooth returns over the longer-term and limit downside risk as various asset classes tend to behave differently over time. Equities and property values typically rise in value faster than fixed income and cash, but their returns are more volatile. Investors need to choose a long-term asset allocation framework based on their unique goals and risk tolerance and then tactically alter the weights between assets within specific ranges as market, economic conditions and specific investment opportunities change.
Many investors are not aware of the risks they are taking by not having an appropriately diversified portfolio. Some have very high weights to equities and are therefore exposed the risk of not being able to fund their lifestyle if equity markets fall just before retirement. Others have excessive weights to low-returning cash and fixed interest in order to reduce volatility, but run the risk of not building a large enough nest egg.
CHART 2: HISTORIC RETURNS OF CHOSEN ASSET CLASSES
Government bonds tend to provide valuable risk management attributes for long-term diversified portfolios as prices tend to be negatively correlated with growth assets. The long-term historical correlation between Australian equities and government bonds is -0.26, meaning for a 1% fall in Australian equities, bond values tend to rise by 0.26%. Equity and property prices typically rise during periods of stronger economic growth and (modest) inflation, while government bonds tend to rise when inflation is falling or the economic outlook is less certain.
Cash also has beneficial diversification attributes, having for example almost zero correlation to Australian equities. Cash is the least volatile of the asset classes and besides providing returns of its own, possesses valuable optionality in that it can be readily applied to transient attractive investment opportunities made available by the market.
Property provides investors exposure to rental returns and property asset prices which tend to be more stable than equity earnings and prices, notwithstanding the excessive rise of debt by many real-estate investment trusts in the lead-up to the global financial crisis which commenced in 2007. Equity and property markets tend to move in a similar direction over time, but typically not by the same magnitude.
Diversifying portfolios to international equity markets, held in combination with core Australian equity holdings, permits access to different regional economic forces with their various monetary and fiscal settings, the world’s strongest businesses and an array of currencies. As such, potential overall returns are enhanced, and volatility can be reduced over the long-term because each market is less than fully correlated. Risk-adjusted returns are therefore enhanced. Investing internationally also helps offset the strong bias to financials and resources sectors within Australia’s equity market.
Markets frequently appear cheap or expensive relative to their prospects based on fundamental income and growth factors. We have an active approach to portfolio management, meaning we tactically adjust our portfolio tilts to take advantage of market opportunities to reduce the risk of capital losses and enhance potential returns.
CHART 3: ASSET CLASS CORRELATIONS TO AUSTRALIAN EQUITIES
Buffett’s two rules of investing: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1”.