Also notice how volatile the returns can be. An asset class that’s top of the pops one year can be at or close to the bottom the next and the average range of returns in any given year is more than 30 per cent. The same is true of returns within each asset class: for Australian shares it’s more than 50 per cent, for international it’s more than 60 per cent and for US shares it’s more than 80 per cent.

Your asset allocation should reflect your risk profile. When you’re constructing a portfolio, risk is looked at in terms of volatility, or the severity of the ups and downs you are liable to experience. If your entire portfolio is invested in Australian shares but you don’t think you’ve got the stomach for a roller-coaster ride that could take you from +30 per cent to -20 per cent or more, then you need to diversify to build in some shock absorbers to your portfolio.

There are a couple of ways to do that. First, you blend “growth” assets (shares and property) with one another, because they can move differently so when they’re combined the overall volatility is reduced. Second, you include some “defensive” assets (fixed income), like bonds, and the ultimate airbag, cash. That way you’ll have something in your portfolio that zigs when the rest zags.

This idea is shown by the lime green boxes in the table, which are a blended 60:40 portfolio meaning it’s 60 per cent growth assets and 40 per cent defensive. You can see the annual returns are in a much tighter range, so while that portfolio will never get bragging rights at the top of the table, neither will it ever be at the bottom. You’ll have given up just under 2 per cent average annual returns against a portfolio of Australian shares, but you only have to put up with half the volatility.

If you think the returns are a little lower than you’d like and you’re sure you have a higher tolerance for risk in your portfolio,you can increase the proportion that’s invested in growth assets. “High growth” portfolios can be up to 90 per cent growth assets – but of course with the higher potential return comes much greater volatility.

Over time markets move up and down and so will your asset allocation, which means you’ll need to rebalance from time to time. It’s a good idea to look at it at least once a year.

There are two approaches you can take: “static”, where you rebalance back to the exact same blend; or “dynamic”, where you aim to increase your weighting in those asset classes that offer the best relative value. There are devotees of both approaches and each has its merits.

One great thing about static is it’s much more straightforward. You can use Vanguard’s asset allocation tool to work out the long-run average return on growth assets and what combination of defensive assets you need to hit your required returns, keeping in mind you should allow for a 50 per cent pullback in the growth assets to test your risk tolerance. Then you rebalance to that over time.

 

One of the best arguments in favour of the dynamic approach is that sometimes a particular asset class gets way overvalued. For example, just before the global financial crisis Australian shares and property trusts were historically expensive and it paid off handsomely to reduce exposure. The hard part about using the dynamic approach is working out the relative value of the different asset classes, which is a seriously specialised job.

James Weir is a director of Steward Wealth.

Asset allocation is the process of working out how much of your portfolio you’re going to invest into different asset classes – like shares, property and bonds, for example. James Davies

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