Choose the right mix of investments to suit your goal
In a previous post we looked at how a mixture of two lowly-correlated investments can both increase return and reduce risk, or increase return for the same level of risk. In real life you’d put your money into more than two investments. The simplified two-investment example is the base on which we will build a portfolio of investments and, by carefully selecting the right investments, we can produce a portfolio made up of a broadly-diversified range of assets which can give the return and risk level that suits any investor’s goals and risk appetite. The two-investment example used bonds as the low return, low risk asset and equities as the high return, high risk asset.
It’s all in the blend
Some readers may buy their coffee with a certain flavour profile in mind. Coffee shops can create different coffee to suit all tastes by blending different beans, with light or dark roasts and fine or coarse grinds to provide just what the coffee connoisseur is looking for. It’s the same with investments. No matter where you want to be on the risk/return curve we talked about in our last post, investments with differing risk and return characteristics are often pre-made by fund managers and super funds to give investors a simple, one-stop-shop. These funds are referred to as pre-mixed, multi-asset or diversified funds and can be a valuable and cost-effective vehicle for investing. Your superannuation is probably invested in one of these pre-mixed funds right now.
Instead of blending two investments, multi-asset funds typically blend two investment asset classes. These asset classes are bonds — which, as we know, have lower risk and lower return, and are referred to as defensive assets — and equities — which have higher potential returns and higher risk and are referred to as growth assets. It’s the ratios of each of these asset classes and the makeup of the investments within each class which contribute to the overall risk and return of the fund.
Although some fund managers offer much more complex blends of assets we’ll investigate some typical examples and see what they can deliver from a risk and return perspective.
Least Risky, Lowest Potential Return
A blend with the lowest risk and lowest expected return is usually called a Defensive fund. In the example shown here, which is a typical allocation for a defensive fund, it’s loaded up with 70% cash and bonds (shown in the inner circle). Only 30% has been allocated to equities which are expected to assist with providing some capital growth and inflation protection. Don’t be put off by the name or this blend’s lower expected return. Its primary objective is to maintain the value of the investment while providing income in the form of the coupon payments from the bonds. As we know, bonds and cash have very low price volatility (ie, risk) so a portfolio with a 70% allocation to assets such as these will offer a great deal of capital protection to an investor.
Looking more closely at the chart you can see by the allocations with each asset class (the segments of the outer ring) that this portfolio is well-diversified among a broad range of domestic and international investment assets. This “eggs in many baskets” approach offers additional diversification benefits within each investment class.
An allocation such as this could be useful to investors close to or in retirement. It may be suitable for investors who might need easy access to their money and for whom a low risk of capital loss is important.
The Middle Way – The Balanced Option
Adding more risk and potential return to your investment portfolio can be done by tilting away from defensive allocations and putting more of your investments in growth assets. In the Balanced Portfolio option we usually see a 50:50 allocation to bonds and equities. Looking at the diagram to the right we can see that the entire allocation to cash, and some of the bond allocation has been replaced with greater proportions of the investment being placed into various equity investments. You’ll also see that, for the equity exposures, there’s a broad spread of domestic and global equities. In addition there are small allocations to emerging markets and global small companies. These allocations make up less than 10% of the total investment but can deliver some additional performance and diversification benefits to the portfolio.
A balanced option is a potentially useful allocation for a medium-term investor or someone in mid-career for whom capital stability with higher growth potential is desired; for someone who still has time on their side to recover should the market turn down but who is content to have the assurance of a large defensive allocation.
More Risk and More Potential Return
For investors early in their career who have time on their side a large allocation to risky assets may provide strong capital growth to their investment portfolio and create a firm base for later in their life. A growth-orientated portfolio, such as the one illustrated at left, gives broadly-diversified equity allocations with some stability from global and domestic bonds. Looking at the inner ring, we now have 70% of our investment in equities, which has the potential to significantly affect the growth of the portfolio. A younger investor early in their career has the benefit of time and risk tolerance which allows for a greater proportion of their investment to be in risky assets whose return potential is very desirable with a long working and investing life ahead of them.
An investment portfolio such as this may be the right thing for a younger investor or one who has a long time horizon and high tolerance to market downturns.
Benefits for you
Pre-mixed funds offer some great benefits for investors. With one decision you can choose where on the risk/return spectrum you’d like to be and, even better, as the value of each of the components of your investment changes, your investment manager or super fund will automatically rebalance the investments back to your chosen blend so your investment stays true to your intentions. Additionally, you can change your allocation whenever you like just by contacting your super fund. So, as your career progresses you can reassign your investments to change the characteristics of your portfolio: you may choose to reduce the risk in your portfolio as you approach retirement to give your savings some more safety as your tolerance for a capital loss becomes less. The choice is up to you.
Super funds typically offer a greater range of blended portfolios than the three examples here. Check with your fund and see what they have to offer, and the different fees they may charge for each of them. Your financial adviser will be very helpful in guiding the best choice for you and your circumstances.
Check Your Super Fund
We’ve spoken briefly about this in a previous Small Change post but now is a good time to restate the guidance. When you joined your superannuation fund you may not have taken much notice of the manager being used or the allocation of your investment assets. It’s a confusing time when you start at a new employer and you’re asked to put your signature to all manner of paperwork. In any case, take some time now to check the allocation of the investments in your super fund. In many cases if you didn’t explicitly select an investment option you may have been, by default, put into the least risky option which is likely to be something like that shown in the first example. If you’re young then this is potentially the wrong option for you and, over a career, you may be losing out on the growth that an larger allocation to shares could provide.
And, finally, a reminder that the opinions in this post shouldn’t be interpreted as being financial advice. At The Money Question we’re not allowed to give advice. If you feel that you need further information then a financial adviser is the best place to go. The information we’ve given here is very general and hasn’t taken any particular circumstances into account. Please refer to our Legal section.