I don’t understand asset allocation in any but the simplest of terms. Could you explain to me why I should allocate across different asset classes and regions?
Dear Whimsical Allocation
You’ve addressed one of the most important issues in investing head on. Multiple empirical studies have found that asset allocation is the primary driver of a portfolio’s expected return.
Let’s consider a hypothetical ‘balanced portfolio’, allocated as follows:
- Growth Assets 60%
– international shares: 25%
– domestic shares: 25%
– property: 10%
- Defensive Assets 40%
– fixed income: 30%
– cash: 10%
This allocation might be relevant for someone in the middle of their accumulation phase – it is not “mostly growth” nor “mostly defensive”, as might be relevant for someone earlier in their life cycle or approaching retirement respectively.
The reason for an allocation between all these different asset classes are risk, return and diversification.
Let’s address risk and return first:
Growth v Defensive allocations
Investors allocate between Growth and Defensive in keeping with how aggressive or conservative they wish to be.
Growth Assets, over the long term, tend to have higher volatility and higher expected returns relative to Defensive Assets. Without going too deeply into the economic fundamentals which drive this relationship, Growth Assets, take for example shares, have an uncertain future income stream., and rank lower in terms of security in the event of a wind up (or sale) of the company. Put simply, unlimited upside as well as downside.
Defensive Assets, for example fixed income and cash, on the other hand, typically receive a known income stream and rank higher relative to shares on a company’s balance sheet in the event of a wind up or sale. Less downside, but also less upside.
Economic interactions between how many people are employed and how much they spend, interest rates, costs of good and services etc is captured by share prices via expected return, made up of dividends and capital growth. The variability of realized return is called volatility.
The big levers of asset allocation is the Growth versus Defensive split. Typically investors allocate more to growth assets in the early, accumulation part of their investment life cycle – when their wealth is low, there is a long term to maturity and they can handle the volatility that may come with investing in growth assets. Later in their lives, closer to retirement, investors typically allocate more to defensive assets over growth assets.
Having put your hands on the big levers, Diversification is a means to manage risk.
An income stream from multiple investment vehicles that don’t all move in the same direction at the same time is likely to be higher and more reliable than if it comes from just one asset.
Once within an asset class there is even more benefit to be gained from diversification. Having an equity portfolio of just one stock is an extremely risky strategy compared to one that invests in a diversified portfolio of international and domestic shares, for example. Where risk is measured by expected return – one share is going to be more volatile than a portfolio of shares, even if they have the same expected rate of return.
With international diversification you benefit from diversification across sectors and not just stocks. For example, financials form 19% of a relatively standard global capitalization weighted index. In Australia, financials form closer to 45%. Australia is, therefore, relative to a global portfolio, quite exposed to shocks to the financial sector.
The “Materials’ sector forms only ~5% of the global portfolio, but closer to 13% of an Australian portfolio. Information Technology forms 15% of a global portfolio, but only 1% in a domestic portfolio. In Australia, if commodities and mining (materials) decline in value with a slowing in China, we don’t necessarily have exposure to enough other, different sectors, like software and software services, to pick up the slack.
Hopefully this high level explanation gives you a basic understanding of the concept of asset allocation, along with some of the key levers that are usually used to construct a ‘balanced’ portfolio.