17 Nov Strategic asset allocation: Why diversifying is key
The importance of a good asset allocation plan and its significance on our investment returns has been highlighted by the recent volatility in South African and international financial markets.
Asset allocation can be defined as the proportional amount of money invested by ourselves in a variety of investments or asset classes. Traditional asset classes are investments such as shares, property, cash and bonds. In recent years other asset classes such as hedge funds have been added to the traditional asset class mix.
Asset allocation plan dictates portfolio returns
Research has found that over time, asset allocation dictates over 90% of portfolio returns. This means that it is far more important that we are exposed to the appropriate levels of, for example, shares and property, than it is to try to pick the individual shares and properties making up the portfolio.
It was also found that the percentage of a person’s portfolio allocated to the various asset classes is what determines the long-term returns on the portfolio.
Good reason to diversify?
The variability of returns in the various asset classes from year to year is a key reason as to why we should diversify our investments across all the asset classes. As no-one is sure what future investment returns are going to be for any of the asset classes, the best way to capture future returns is to spread investments across the asset classes.
All investments carry risks. Many investors believe that money in the bank is the least risky of all investment options. However, investors must remember that the after tax return on cash is very often less than inflation, resulting in the investor’s purchasing power being eroded. This effect is what is often referred to as investing oneself poor.
Research tells us that better long-term returns can be obtained from shares and property when compared with cash, although in any one year, due to the volatility associated with shares and property, this might not be the case. Shares and property need time to recover from short-term dips that they might experience and it is important that the greater an investors share exposure, the longer the timeframe for which he or she will remain invested.
When considering the appropriate asset allocation plan for an investor, the timeframe facing the investor is of great importance.
It makes sense for an investor to invest some funds in stable, lower yielding cash-type investments, and some funds in higher yielding more volatile share and property investments. A financial planner should assist you in determining the return that is required on your investments and access the asset allocation necessary to achieve this return. At this point, it is vital that one understands the risk and volatility to which the investment will be exposed, and the risk tolerance of the investor must be considered when determining asset allocation.
Diversification is the best form of reducing the risks inherent in investing. The best way to diversify is to invest across all major asset classes and also within all asset classes.
Wise Jill, foolish Jack
To illustrate the importance of diversification across asset classes by way of an example, consider Jack and Jill. Jack invests all his savings in the stock market, while Jane invests 50% in the stock market and 50% in cash-type investments. If the stock market were to fall by 30%, Jack would lose 30% of his total wealth. Jane, on the other hand, would lose 15% of her wealth due to the stock market crash, but would make 5% back due to the interest earned on her cash holdings.
Her total loss would be 10% compared to Jack’s 30% loss. Alternatively, if the market were to climb 30%, Jack would enjoy a 30% gain, while Jane would only enjoy a 20% gain.
In much the same way, diversification within an asset class (e.g. within the share market) ensures that when a particular sector of the share market is affected by a severe downturn (e.g. Information Technology) the other sectors of the market (e.g. mining, retailing) may not be affected.
Another important type of diversification is regional diversification, which allows investors to have exposure to investments in other countries as well as exposure to various currencies.
The bottom line on an asset allocation plan
Diversification helps investors hedge their bets against unforeseen circumstances and reduces exposure to volatility. Stories abound of people who have made a lot of money from a particular share or property, but this may have more to do with luck.
The use of asset allocation adds value to investment portfolios and reduces risks when investing. It is crucial that investors understand the concepts of diversification, appropriate timeframes and risk tolerance.
This will ensure good returns while allowing for personal risk tolerance preferences so that an appropriate portfolio of investments can be selected.
Debbie Netto-Jonker CFP® is the founder of Netto Financial Services and was Financial Planner of the Year in 2001. Her business partner, Ian Beere CFP® was the Financial Planner of the Year in 2007.