Asset allocation. You'd think one of the most important topics in investing would have a sexier name, but hey, that's the industry for you. While investors fret about which ETF they should buy, or who is going to be the next Afterpay, asset allocation is one of the most crucial and far-reaching investment decisions a young investor will make.

Put simply, asset allocation is how much of your portfolio (the money you have to invest), you allocate to each asset class, such as equities, bonds, cash, property or alternatives. You could put 100% of your money in a single ASX stock – that would be a 100% allocation to Australian equities – but you'd be hard-pressed to find anyone who thinks that's a good idea. Similarly, having most of your money in cash, in this interest rate environment, isn't going to get you very far. Remember the idiom don't put all your eggs in one basket – what if it doesn't work out?

Investment researchers advise you to spread (diversify) your money across a range of asset classes. If done correctly, it protects you against everything on a bad investment and limits your volatility (how much your portfolio goes up and down). The theory goes that you should diversify across asset classes that don't behave alike – one goes up while the other goes down, what the industry calls ‘negative correlation’ – reducing your portfolio's overall risk. The goal here is to craft an "efficient" portfolio for your investment goals and time horizon - a portfolio that offers the highest expected return for a given level of risk.

The question is how do you put this into practice? The conventional wisdom is that as stocks deliver more risk than bonds, investors should gradually shift more of their portfolio into bonds and cash as their get older, to protect the capital needed in retirement. But that’s not much help to a beginner. How do you start out? Unfortunately, there is no perfect asset allocation formula – everyone has a different idea about what will make the most efficient portfolio. Plus, investment markets are constantly changing; the riskiness or defensiveness of an asset class and its correlation to other asset classes is not static.

It would be ideal if we could all position our portfolios to capture stocks' returns when they're going up and then move into safe investments right before stocks go down, but if you could do that with accuracy, you wouldn't be reading an article about how to build a portfolio. Rest assured, nobody can do that with consistent accuracy even after decades in the market.

You could rely on someone else to do the hard work for you. Financial advisers pride themselves on developing asset allocation models and placing their clients in the ideal portfolio for their risk tolerance. You still need to understand what's going into their assumptions. Even an adviser who invests you entirely in passive funds (either unlisted or ETFs) is making very active asset allocation decisions. For example, they may be taking a bet on the defensiveness of gold, the riskiness of currency fluctuations or the growth of emerging markets. 

Asset allocation guidance is also provided by super funds, multi-asset investment funds and research houses (like Morningstar). But likewise, opinions vary about the optimal mix.

Here's some free advice from Morningstar. This week, Graham Hand, who has been writing about investing for 10 years (following a 35-year career in financial markets), responded to the challenge 'if you could give just one piece on investing advice …'

His advice for early-stage investors:

"Allocate as much as possible to a diversified portfolio of growth assets, mainly shares, based on your risk tolerance and a long-term time horizon of at least 10 years and preferably up to 30 years."

Pretty sound advice if you ask me, and the foundational idea I built my first portfolio on.

He notes that during the 30-year period, at some time the stock market will fall 40% to 50%He's not wrong. Over the last 30 years, the US market has experienced three major crashes - the covid-downturn, the GFC and the tech bubble. But your portfolio will recover from major falls if you have a long-term mindset and stay invested.

If you don't have the stomach for losing half your portfolio, then you don't have the risk appetite for a large allocation to equities. Wind it back to 80/20 growth v defensive or 60/40, Hand advises.

Market crash timeline

Get some perspective

If you want the clearest demonstration of why it's important to stay the course through extreme market volatility and maintain a long-term perspective, check out Vanguard's annual reminder (published last week). According to the chart, an initial $10,000 investment in the broad Australian market in 1991 would have grown to $160,498 in 2021, yielding on average 9.7 per cent. The same amount invested in the broad US market would have grown to $217,642, returning on average 10.8 per cent.

But if an investor cashed out when markets dropped in March 2020, missing the rapid rebound and continued growth, they would have been $55,843 worse off. Investors who similarly exited US shares would have been $60,344 worse off. 

Print it out, stick it on the wall - check that every day, not the market.

2021 Vanguard Index Chart
Market returns - 1 July 1991 to 30 June 2021

Vanguard’s 2021 Index Chart

(Click to download) Source: Vanguard

Morningstar's annual gameboard also shows there is no pattern. Winners and losers change from year to year demonstrating the risks of selling your losers. Hand says it also emphasises the poor returns from cash and bonds in the TINA ('there is no alternative' to equities) era.

Asset class returns

(Click to download) Source: Morningstar

Simple, low-cost funds

Hand believes the best long-term choice are broadly-diversified, low-cost index funds – domestic and global – plus some active management if you consider a particular fund to be "worthy".

"Add some small and mid-caps and include assets such as infrastructure and property to diversify further," he adds. "Most of the rest goes into a diversified bond fund with say 5% left over for some fun."

Implicit in Hand's advice is to start early and invest often, building up a portfolio overtime. Hanging on for the long haul means you need a 30-year view. And when should you start? Right now. As Hand says, you can always find someone who will tell you that a market crash is imminent, but few people can pick market returns consistently. 

For more insights, Mark Lamonica devoted an entire one-hour webinar to the topic of asset allocation on Thursday night, plus took half an hour of questions from the audience. Grab a cold one and listen in (coming soon on YouTube). His main point was that asset allocation should be the direct result of your financial goals, time to reach those goals and your risk capacity.

"Whereas risk tolerance is how much risk you think you can handle, risk capacity is how much risk you need to take to achieve your goals," he said.

"Investing is nothing more than a means to an end. A portfolio that makes you comfortable is of little use if you don't reach your goal."


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