Have you looked at your friendship group lately? Most of us surround ourselves not only with people from similar backgrounds to ourselves, but also with people from different countries, with varying personalities, hobbies, likes and dislikes. For all these subtle differences, everyone can still work together and get along.
Similarly, when investing and constructing a diversified portfolio we can look at the compatibility of different types of assets, and how a range of assets can provide a good outcome overall. This is what we call ‘asset allocation’. The right combination of different asset classes can not only help drive long-term growth but also benefit your portfolio when there is market volatility and drawdowns.
What is asset allocation?
Asset allocation is the process of distributing the funds you have to invest into growth and defensive assets. Typically we think of equities as growth assets, and bonds and cash as defensive assets. The goal is to align your asset allocation with your tolerance for risk and time horizon.
Looking more closely at these three main asset classes:
- Equities – Familiar to most investors, equities typically offer the potential for higher returns, but with higher risk. Typically, equity exposures come via direct stocks (domestic and international), ETFs, unlisted managed funds, and Listed Investment Companies (LICs).
- Bonds – Often less well understood, bonds play an important part in diversifying your portfolio and helping to balance the risk of your growth assets. Fixed income exposures historically have provided a lower return than equities.
- Cash – Under the mattress or in a bank account, this investment will be very low risk but also won’t give you much return.
Risk tolerance can be thought of as how much of your investment you’re willing to lose for the chance of achieving a greater rate of return. If you can handle swings in the market, that indicates you likely have a higher risk tolerance, but if you don’t want to see large movements in your portfolio value you probably have a more conservative risk profile.
This is important to understand, because your risk tolerance influences asset allocation by determining the proportion of aggressive and conservative investments you hold. On a simple level, this means the percentage of stocks versus bonds and cash you hold.
Another thing to consider when determining your asset allocation is the timeframe you have to invest. For example, you might psychologically feel comfortable with market movements, but if you potentially need to access your funds in a short timeframe you may have to adjust your risk profile down.
Strategic asset allocation
Once you understand your risk tolerance and investment time horizon you can formulate your strategic asset allocation. Strategic Asset Allocation (SAA) refers to a long-term portfolio strategy that involves choosing asset class allocations and periodically rebalancing to that allocation. An SAA is used to diversify a portfolio with the aim of generating the highest rate of return at a given level of risk.
Asset allocation through ETFs
Once you have determined your desired asset allocation, there are a few ways to implement that allocation to equities, bonds and cash. Investing directly in individual stocks and bonds can be complex, time consuming and potentially expose your portfolio to additional risk. An alternative is to use ETFs to construct your portfolio. ETFs can make the process simple and cost-effective, while also providing transparency and diversification. One way of doing this is to choose one or more ETFs for each asset class.
For example, for your Australian equities allocation you could use an ETF such as the A200 Australia 200 ETF which provides diversified exposure to the top 200 stocks listed on the ASX, for a management fee of just 0.07% p.a.*
You could use an ETF such as the OZBD Australian Composite Bond ETF for your core Australian fixed income allocation. OZBD offers the opportunity to earn regular, attractive income from a diversified fixed income portfolio including Australian government and semi-government bonds, supranational and corporate bonds.
There is a broad range of ETFs available on the ASX that you can use to construct the equities, fixed income, and cash parts of your portfolio.
Your risk tolerance and investment timeframe will determine the percentage of your portfolio you allocate to each asset class.
You can simplify things even further by making use of a diversified ETF, which takes care of the asset allocation for you.
A diversified ETF is a fund that itself is made up of several ETFs, covering the asset classes discussed above. A diversified ETF is typically constructed to suit a particular risk profile, with the allocations across the component ETFs seeking to be consistent with that profile.
For example, the DHHF Diversified All Growth ETF is an all-in-one investment solution that provides low-cost exposure to a diversified portfolio of large, mid and small cap equities from Australian, global developed and emerging markets. In a single trade you get access to approximately 8,000 equity securities listed on over 60 global exchanges, with management fees of just 0.19% p.a.* DHHF may be suitable for investors with a high-risk tolerance.
There are risks associated with an investment in the Funds mentioned, including:
- A200: Market risk, security specific risk, industry sector risk and index tracking risk.
- OZBD: Interest rate risk, credit risk, market risk and and index tracking risk.
- DHHF: Asset allocation risk, market risk, currency risk, underlying ETFs risk and index tracking risk.
For more information on risks and other features of the Funds, please see the respective Product Disclosure Statement.
*Additional fees and costs, such as transactional and operational costs, may apply. Refer to the PDS for more detail.
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Ben brings a unique blend of financial acumen and creative storytelling to his role. With a solid background as a portfolio analyst, Ben possesses a deep understanding of the financial markets, investment strategies, and how ETFs work.Read more from Benjamin.