This concept is commonly known as Modern Portfolio Theory ("MPT") and was proven by Nobel Prize-winning economists Drs. Harry Markowitz and William Sharpe who studied the effects of diversification on a portfolio's overall risk level.
Asset Allocation refers to what percentage of your portfolio you invest into the various asset classes such as Shares, Property, Commodities, Fixed Interest, Cash, etc, and is probably the most important step in terms of setting your expected return and volatility expectations. As each asset class has a historical set of return and volatility characteristics, it allows you to set an asset allocation that gives you a reasonable expectation of fulfilling your overall investment objectives, yet constrained by your tolerance for risk & volatility.
As mentioned in the step by step SMSF investment process page (if you haven't read it, go there now), your investment objectives and return expectations need to match your risk tolerance, and you need to understand that those asset classes that have the potential for higher returns, also have a higher risk and volatility attached to them.
As many trustees may be unsure of where to start with asset allocation, we have provided below some examples of various static asset allocations for a variety of corresponding investment objectives and risk tolerances, and stages of life. However, before you go there, you need to decide if your going to have a static or active asset allocation.
Static asset allocation is where you set an asset allocation based on your objectives, stage of life, cashflow requirements, and risk tolerance, and you stick with it through thick and thin and ride out the market cycles, with maybe a little bit of adjustment as time goes by. The advantage of this approach is that it is low maintenance, and you will basically get what the markets will give you. This is how most people are invested in regular commercial superannuation funds. The main downside of this approach, is that if the capital markets (especially the growth ones such as the stock market or property market) go through a large decline, and then enter into a protracted period of going nowhere (yes it can, and has happened before !!) then you are going to go through a fairly miserable time in terms of your returns if you have a large allocation to these asset classes.
Active Asset allocation on the other hand is more dynamic. It usually starts with one of the static asset allocations based on your objectives, stage of life, cashflow requirements, and risk tolerance, but will then take you partially or fully in or out of an asset class based on what is happening in the real world to those asset classes at that point in time. For example, say you are a 'Balanced' investor as found in example three below (see Example 3 asset allocation sample below), and that you are currently fully invested as per those allocations. However, you are now concerned about the share market, and believe (based on any number of investment tools and indicators that you may use) that the market is way overvalued, and that due to this and evidence of a deterioration in the economy, that the prudent course is to step out of the Equities asset class and assign those monies to cash until your research indicates that the higher than normal risk you perceived in equities has receded to a point that your happy to invest again. Note that although Cash can go up to 100%, the other asset classes will only be invested in up to the maximum % allowed by the static asset allocation your using as your benchmark. The main advantage of active asset allocation is that it provides the potential to not get stuck in an asset class that goes through a really bad protracted downturn (e.g. the stock market of 2008). The disadvantages are that, while the previous sentence sounds easy, the reality is that it is not. If you get the timing wrong, such as selling out after the market has gone down substantially, and then it rallies up again and your not there, you can be hit with a double whammy. The bottom line is that if you are going to use an active asset allocation strategy, you will need investment research / tools / indicators that have a history of getting it right to enable you to make the most of this kind of strategy.
**Important note: these are examples only, and are only a small sample of the many many combinations that you could come up with. With these examples, we've only stuck to the main asset class categories. What is also important is that if you have a core competency in a particular asset class (e.g.say you work in the area of direct property, or art dealing etc), then your asset allocations may look quite different to these, as you'll be skewed towards your area of expertise. Keep in mind however, that diversification is still a very valid method for reducing single asset class risk.
Note also that we have not distinguished between Australian and International equities (they are combined in the Equities asset class). While many list these separately, we have not as their characteristics are very similar, they are just geographically different. How much of each is up to your personal preference.
Example 1. - "High growth" asset allocation
Member is in the accumulation phase, with at least 15 years until retirement
Investment objective of 12%+ pa long term returns
Risk / volatility tolerance is rated as very high
Example 2. - "Growth" asset allocation
Member is in the accumulation phase, with at least 10 years until retirement
Investment objective of 10%+ pa long term returns
Risk / volatility tolerance rated as high
20% Fixed Interest
Example 3. - "Balanced" asset allocation
Member is in either the accumulation or pension phase
Investment objective of 8%+pa long term returns
Risk / volatility tolerance rated as moderate
45% Fixed Interest
Example 4. - "Conservative" asset allocation
Member is in the pension phase (or accumulation phase if low risk is required)
Investment objectives of 6%+ pa long term returns
If in pension phase, regular income needed, but still need some long term capital growth
Risk / volatility tolerance rated as low
60% Fixed Interest
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