2 things you need to know about asset allocation
Asset allocation is one of the most important concepts in investing. It’s the notion that investing across a broad array of asset classes helps reduce the risk attached to a portfolio, and there are 2 important variables that can help you determine the right asset allocation for your SMSF.
Asset allocation is one of the most important concepts in investing. It’s the notion that investing across a broad array of asset classes helps reduce the risk attached to a portfolio. The underlying basis for this concept is that by diversifying the basket of investments held in an SMSF, there is a greater potential to smooth out the returns of the fund.
Deciding the right asset allocation for your fund is personal to the members of the fund. At the start of this process it’s essential to build a set of criteria to establish the right mix of asset classes held by the fund, so that it can meet the long-term investment goals of the fund members.
There are two important variables that help to determine the right asset allocation for the fund members. These are the time horizon and the risk appetite of the members.
The longer an investor has to invest, generally the higher the appetite for risk. In addition, the more time an investor has to invest, the more time the portfolio will have to ride out periods of market volatility. Conversely, if an investor only has a short time to invest, the lower the appetite for risk, generally, and the higher the likelihood will be for the investor to choose a selection of lower risk assets.
The second variable that will help determine the right asset allocation for your fund is risk appetite. The higher your tolerance for risk, the more inclined you will be to invest in assets such as shares. The lower your appetite for risk, the more inclined you will be to invest in lower risk assets such as fixed interest securities.
You, or your financial adviser, can determine your risk appetite by reflecting on a number of different factors, such as how cautious you are generally, whether you have invested in risky assets in the past and whether this has achieved the return you desired, as well as your propensity to put your money at risk for a potential reward. Generally, investors will be categorised as either having a low, medium or high risk appetite.
It’s also essential to understand the relationship between risk and return when determining the correct asset allocation for your SMSF. Generally, the higher the risk attached to the portfolio, the higher the potential for return. Conversely, the lower the risk, the lower the potential for investment gains.
It’s also important to look at the correlation between the asset classes you’re allocating to. When asset classes are highly correlated, market movements will impact them in similar ways. This allows you to ensure you build a defensive part of your portfolio that in the case of say, a share market downturn, the defensive portion should not follow the same downward trend, reducing the overall portfolio risk.
After you have determined your time horizon and risk appetite, the next step is to understand the different risk profiles of the various asset classes to determine the appropriate asset allocation for your fund. Domestic and international shares sit near the top of the risk spectrum, property and infrastructure is less risky, fixed interest falls below that and at the bottom of the risk pyramid is cash. Simplistically, you need to consider the potential for each asset class to deliver a percentage return and apportion your funds across the asset classes to help you reach your investment goals.
Asset allocation is something that needs to be regularly reviewed, ideally twice a year or more, to ensure the mix of investments in the fund is still aligned to your investment goals. It often can help to seek advice when determining the right asset allocation for your fund.