Ignore asset allocation at your peril

While it’s easy to get caught up in the rags to riches investor tales of GameStop or Telstra’s fully franked dividend, asset allocation deserves more attention from investors. It is readily overlooked and often misunderstood, even though it is critically important to an investor’s long-term returns. It is a very personalised decision and goes beyond the meaningless, and occasionally misleading, "balanced" label slapped on so many super funds. So, it’s time to take a moment away from picking tomorrow’s big winner and work out the right asset allocation for your portfolio.

What is asset allocation?

Asset allocation is the mix of international and Australian-based assets that make up your portfolio–including shares, property, infrastructure, bonds, and cash. In fact, academic studies like that of Brinson, Hood, and Beebower (1986), indicate that more than 90% of the variability of investors returns are determined by asset allocation. So, the investment returns that you are seeking over time are largely driven by what proportion of these assets you own. That is, if you own more shares (or growth-oriented assets), over a very long period of time you can expect a higher return. But in the short to medium term, you should be prepared for market ups and downs. Conversely, if you hold all your money in cash and bonds (or income-oriented assets), expect to earn a lower total return (particularly if you consider the impact of inflation), but a relatively stable investment.

The simplistic expected return ladder in Exhibit 1 shows how income-oriented assets are expected to produce lower returns, while growth-oriented assets are expected to produce higher returns. The starting point on the ladder is an at-call cash account earning 3%. The next rung of the ladder are bonds (simply a loan you make to the government or to a company). The additional 1% return expected is attributable to the longer holding period (as at-call cash can be accessed daily) and the increased credit risk (that is, uncertainty that the loan will be repaid). Finally, equities are riskier still, and various studies have concluded that investors require an additional 3% and 3.5% to hold equities over bonds. This means that if we earn 4% for bonds, expect returns of approximately 7% from equities.

Exhibit 1: Simple Expected Return Ladder With Stylised Expected Returns

Source: Morningstar

What is the ‘right' mix of assets for your portfolio?

Unfortunately, the answer is that "it depends." Determining an appropriate asset allocation is a very personal decision. It depends on your goals, your time horizon to achieve those goals, and your risk capacity. Using a goal-setting tool is the most comprehensive way to work out the right asset allocation for you. For those who prefer rough rules of thumb, 100 (or more recently 120 as life expectancies creep higher) minus your age should be allocated to growth-orientated assets. So, if you’re 30 years old, between 70% and 90% of your allocation should be in growth-orientated assets. Conversely if you’re 70 years old, it should be between 30% and 50%. This is predicated on the idea that younger investors have longer time horizons and therefore have the capacity to take on more investment risk.

What does ‘balanced’ mean?

Many premixed, diversified portfolios are described as "balanced." But it’s important to look beyond this label and understand the asset allocation of the fund and whether it is appropriate for your goals and time horizon. Exhibit 2 shows that the allocation to growth-orientated assets can vary materially between funds–even though they are described as balanced.

Exhibit 2: Comparison of asset allocation for 3 balanced funds

Source: Morningstar

1 Vanguard Balanced Index Fund Factsheet as at 30 June 2022.
2 APRA MySuper Heatmap as at 30 June 2021.
3 APRA MySuper Heatmap as at 30 June 2021.
*Note that the Hostplus Annual Report 2021 reports a 5% allocation to cash and bonds.

There’s normally a good reason some funds will take on higher allocations to growth-oriented assets. Historically, balanced funds are where the majority of investor assets have ended up, and as a result they are now typically the default option. This default option is often tailored to the needs of the "average" member as defined by a member’s age. For example, the average Hostplus member is in their mid-30s ; according to Hostplus' 2021 Annual Report, more than 69% of its membership is invested in its balanced option. Remember, based on the rule of thumb–these members (on average) should have around 70% and 90% of their asset allocation in growth-oriented assets. This higher allocation to growth assets is designed to avoid the younger average member base taking on too little risk and earning lower returns over time. But if you don’t fit the average investor profile and are instead 70 years old, it’s probably worth considering whether this asset allocation is right for you.

Ignore asset allocation at your peril

Selecting your mix of growth and income-oriented assets can materially change your outcome, so pick carefully. A 30-something who’d invested $100,000 in Vanguard Balanced Index over the past 10 years (compounding annually) instead of Vanguard High Growth Index would now be $70,000 worse off. Choosing between the balanced and high-growth funds is not like picking a Melbourne Cup winner–don’t just take a guess based on the name, simply because you might feel balanced on any given day. Look carefully at their portfolios and make an educated decision based on your personal circumstances and goals.

Exhibit 3: Vanguard diversified index funds—asset allocation and historical returns

Source: Morningstar

While it might seem far more exciting to choose between buying Rio Tinto and BHP Limited, it’s more important over the long term to set the right mix of income and growth-oriented assets up front. And don’t forget, every few years it’s worth checking in to see how your goals, objectives, or rule of thumb ratio has changed and whether your asset allocation remains appropriate.