Fixed interest and cash: what's the right approach to asset allocation?
With interest rates at record lows, but ongoing volatility in financial markets, deciding how to allocate funds to cash and fixed interest investments can be a tricky process for SMSF investors.
Traditionally these assets have formed the defensive portion of a portfolio, helping to protect it when higher risk assets such as equities are volatile.
But given the low returns cash and fixed interest are delivering in a low or negative interest rate environment, too much exposure can adversely affect overall portfolio performance. Which means it’s essential to approach asset allocation to these categories in a considered way.
Traditionally in a balanced portfolio, 40% of the assets are defensive and 60% are growth. But it can be prudent to take a less static approach. Sometimes market conditions dictate a growth bias. At other times risks are high, and the portfolio should have more exposure to defensive assets. The right approach really depends on the economic and market t cycle and the risk of a short-term market dislocation.
It’s easy given the low yield environment to be tempted into financial products that have some of the qualities of cash and term deposits, but offer slightly higher returns. But with the prospect of higher returns comes higher risk.
Think carefully before increasing the risk in the defensive portion of the portfolio, as these investments are designed to provide lower risk returns in times of market volatility. Allocating to higher-risk products as part of an allocation to cash and fixed interest could defeat this purpose, as these assets may be more volatile than cash through market cycles.
It’s also important to have an allocation to cash in a portfolio to be able to take advantage of well-priced buying opportunities that can arise when markets are volatile.
While it’s easy to assume cash is the easiest part of the portfolio to manage it takes skill to know when to sell assets, take profits and add these to the cash component of the portfolio and when to maintain the portfolio’s cash position.
One common mistake investors make is selling down assets in response to bad news and using the portfolio’s cash to buy assets when markets are overpriced. The best way to avoid this is to use objective analysis to make investment decisions, rather than just react to short-term news and follow the crowd of the market.
This requires more research than simply following the market, but it’s often a more prudent long-term strategy for delivering good returns over time.
Central bank interest rate decisions are one of the data inputs investors must consider when allocating to cash as these have a bearing on the return cash investments produce. As interest rates increase, so too does the return a cash investment will produce and the reverse is also true. Markets are presently watching the US Federal Reserve’s decision regarding interest rates, with an expectation the cash rate will rise this year.
One of the inputs the Fed will use to make its decision is inflation. Central banks generally have a target inflation rate in mind and the cash rate is the main tool at their disposal to influence inflation. In the US this target is 2%, in Australia it’s 2% to 3%. Inflation around the world is at record lows: in Australia for the year to 30 June 2016 inflation was 1%. In the US for July, the year-on-year inflation figure was 0.8%.
If inflation falls central banks can reduce the cash rate, and therefore the return on cash, to stimulate inflation. SMSF investors should be aware of this when allocating to cash.
Central banks can also deploy what’s known as ‘helicopter money’ to try to lift inflation. This involves directly transferring money to private individuals to stimulate economic growth. This would also put downward pressure on cash returns, something retail investors also need to keep in mind.
Cash and fixed interest will always be a central component of every balanced SMSF portfolio. But the correct allocation requires close consideration of the fund’s investment goals, global economic conditions and an appreciation of upcoming events that have the potential to create market volatility.
It’s important to take a dynamic approach to cash and fixed interest, to be able to protect the portfolio during times of market volatility, and take advantage of investment opportunities using the fund’s cash component when market conditions are right.
About the author
Nader Naeimi, Head of Dynamic Markets at AMP Capital. He is also the portfolio manager of the Dynamic Markets Fund.
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