At a very high level, asset allocation is allocating the money that you invest into different types of investments. And many investors think that the most important part of investing is the individual securities you put in your portfolio – which stocks you buy, which ETFs you buy. But in reality, asset allocation may be far more important. One study done by an investor named Robert Ibbotson found that 90% of the variation in returns received came from asset allocation. So definitely something that you need to get right. 

Additional resources:

Tool: Morningstar asset allocation models

Tool: Vanguard asset allocation calculator

Article: Why asset allocation matters and selecting the right approach for your goals. 

Article: Don't confuse hedging with diversification

Proceed to Module 6: How to set yourself up for investing success: Selecting investments

Many investors start with choosing investments. For goals-based investing, it is the last step - and for a reason. It is important that your portfolio is built around your goals, and not around investments. Shani Jayamanne goes through how to select investments in your portfolio that align with the type of investor you are and your goals.

Back to course outline.

Module transcript

Mark LaMonica: Our next module is going to cover asset allocation. And once again, this is part of that structured process we're talking about in how to achieve your investment goals. And we've so far defined the goal. We've talked about the return that you need to actually achieve the goal based on your savings rates and based on, of course, the dollar amount that you need to achieve that goal. And now, we're going to talk about asset allocation. And asset allocation is a really important topic. And we spend a lot of time talking about security selection. So that is what ETF or what share am I going to put into my portfolio. But asset allocation is actually far more important in determining those long-term returns that you are going to achieve.

So, what does asset allocation mean? It basically means what are the different buckets that you are going to allocate your portfolio into. And it can get very, very detailed, but we're going to start out on a very high level. And really what we can do is we can categorize assets into growth assets and defensive assets. So, growth assets are things like shares, listed property, infrastructure. Defensive assets are things like fixed interest or bonds and cash. And at a high level, when we look at these two different groups, we can talk about the characteristics of each one of them.

So, when we're talking about growth assets, what we expect is higher long-term returns. And what we are trading that off for is volatility, which we'll get to in a second. And then of course, when we're talking about defensive assets, we're thinking about lower long-term returns. And so, as you can see, how you allocate your portfolio between those two different high-level groups is really going to determine the return that you get. And so, the theory behind investing is the more risk we take on, so the more volatility we're willing to accept, the higher those returns will be over the long term. So, when we go back and think about that required rate of return we calculated, if it is a higher return that you need to achieve your goals, then you need to tilt your portfolio more towards growth assets. If it's a lower return that you need, then of course we can tilt it more to defensive assets.

So, let's go back and talk about these different assets that go in there. And Morningstar has a bunch of different asset allocation models. And basically, what those models look at is how much you should allocate into each type of asset at a high level between growth and defensive, and then some of the smaller categories within those two large asset allocation categories. And so those asset allocation models are ranging from very conservative short-term investors who of course care a lot about volatility, less about returns, to more aggressive long-term investors who of course are more worried with that return they're going to achieve. And what you'll see in these asset allocation models is you'll see how different amounts of the portfolio are allocated into things like Australian shares, global shares, listed property, infrastructure, government bonds, and then cash. And this can be used as models for investors as they try to think about their own asset allocation.

So, the most important things to do is, number one, come up with an asset allocation that gives you a reasonable chance of achieving your goal. And we'll use two examples, and we'll pretend this as a two-asset portfolio. We don't have any other choices. So, one asset is shares, and one asset is cash. And hopefully, we can use this to talk about some of the concepts that I just went through. So, if we need to achieve a higher return and we need to achieve it over a longer time period, we need to make sure more of our money is in shares. Because if I put all of my money into cash, then I'm not going to earn a very high return. So, cash historically has earned a return that has been just above inflation. And so, cash may feel safe, may feel really safe to have your money in the bank. But in terms of achieving your goal, that's really, really dangerous because you are not going to make your goal, or most people are not going to achieve their goals if they're earning that really, really low return.

Then of course, if we have a portfolio that instead of being 100% in cash is 100% in equities, we have to worry about, of course, that short-term volatility, and we have to worry about making sure that that does not cause us to make poor decisions, like panicking and selling everything when the share market is really low. But over that long time period, of course, then we expect to earn those higher returns. It is the best-performing asset class over the long term in terms of a return above inflation.

So, it's just an example of two different assets. And obviously, a portfolio can be more complex than just those two assets, but it's just an example of those decisions we're making with asset allocation. So, once again, if you establish your goal, if you figure out that return that you need to achieve your goal, very quickly we can start thinking about that portfolio we're going to put together. And we can think about how much we're going to allocate to these different asset classes, and then start worrying about picking individual securities.

So, let's go through some practical examples of what different asset allocations look like. And there's no rule of thumb about where things fall, but if you're looking for returns that are in the 7% and up range, then you need to be more like that aggressive portfolio. And really what that does is it allocates 90% of the portfolio to growth assets. And so, once again, those growth assets are a mix between global shares, Australian shares, listed property, and infrastructure. And those defensive assets would be bonds and cash. And then at the other end of the spectrum, that conservative portfolio for investors with short time horizons and investors that don't need that high of return, 90% of it is allocated to defensive assets, so cash and bonds, and only 10% to growth assets. And then investors that fall somewhere in between, and as I mentioned, there are five of these different suggested asset allocations, of course, as we go from conservative up to aggressive, we're allocating more and more into these growth assets. So, it's really important to set this asset allocation because it's going to be a huge driver of the returns that you actually achieve. And if you care about volatility, if you have a short time horizon until your goal, it's going to be huge determinant of how your portfolio bounces around in value. And that, of course, can be very dangerous if we have a short time period.

As we've talked about throughout all of the modules so far, we're trying to provide a framework that provides structure as you go through the process. And I think we've said multiple times that many investors just jump to the end, and they want to find that share, that ETF that they want to invest in. But we need to set our asset allocation first because then when we start evaluating individual investments, we can see which category they fall in of these different asset allocation categories. And then we can see how much of our portfolio should be made up of those individual investments. So, when we start talking about a portfolio with 90% growth assets, well, all of a sudden, we have a target. We may go into subcategories, as I said, between Australian equities, international equities, et cetera, and break that down a little bit as our asset allocation models show. But then all of a sudden, we can start thinking, okay, how am I going to get exposure to this particular asset class, and how much should I buy? And that can be all sorts of different things. It can be an ETF. It can be a managed fund. It could be an individual share. But all of those will fit into those categories. And then you have more structure. And you also have more structure when you're evaluating your portfolio, which we'll talk about later as well. But once we've set those targets, and we suggest that you write these down, and you know exactly and you're deliberate about what you're trying to do, once we've set those targets, we can then adjust our portfolio as market conditions change.

So, returns obviously are very important in order to achieve our goals. And if we go back historically, we can look at how this has played out. So, if we go back to 1928, and we look at U.S. shares, they have returned an average of 11.5% a year. If we go and we look at bonds, we can see that bonds have returned 4.87% a year. So, you can see that's a massive difference. And study after study have shown that this is the single biggest thing that you can do to determine the returns in your portfolio. You could be the greatest bond investor in the world and go out there and find all the great bonds that you want to put in your portfolio. But you're probably not going to ever achieve the returns that you would get from investing in an index fund in shares. And so, no matter how good of a stock picker you are, no matter how good you are at selecting securities, it's really this high-level asset allocation that's going to drive what you actually achieve. And that can be the difference between achieving your goal and not achieving your goal.