Foundations of financial independence Module 5: Asset allocation

Opinion
15:00 January 08, 2024
By Mr. Oliver Kensington

CFA explains why asset allocation is so important to your portfolio outcomes, how to connect asset allocation to your required rate of return and your goals, and how to put together the exposure you need to reach your goals.

Module 6: How to Set Yourself Up for Investing Success: Selecting Investments

At a very high level, asset allocation is allocating the money that you invest into different types of investments. 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.

Module Transcript

Mark LaMonica:

Our next module is going to cover asset allocation. This is part of the structured process in achieving your investment goals. So far, we've defined the goal and calculated the return you need to achieve it based on your savings rate and goal amount. Now we move to asset allocation.

Asset allocation is about determining how your portfolio is distributed across different types of investments. While security selection (e.g., which ETF or stock to buy) is important, asset allocation is even more critical for long-term returns.

Growth vs. Defensive Assets

We categorize assets into two main groups:

Growth assets: Shares, listed property, infrastructure
Defensive assets: Bonds, cash

Growth assets typically offer higher long-term returns with more volatility, while defensive assets offer lower returns but more stability. Your required rate of return determines how much of your portfolio should lean toward growth versus defensive assets.

Asset Allocation Models

There are various asset allocation models, ranging from conservative to aggressive. These models guide how much to allocate to:

Australian shares
Global shares
Listed property
Infrastructure
Government bonds
Cash

The key is choosing an asset allocation that gives you a realistic chance of reaching your goal. For example, a two-asset portfolio of shares and cash:

If your portfolio is 100% cash, your returns will barely outpace inflation.
If it's 100% equities, you'll have higher potential returns but also more short-term volatility.

Setting a Target

Once you establish your goal and required return, you can set a target allocation:

Aggressive Portfolio: 90% growth assets, 10% defensive
Conservative Portfolio: 10% growth assets, 90% defensive
Balanced Portfolios: Somewhere in between, depending on your time horizon and risk tolerance

This allocation then informs which individual investments you choose — shares, ETFs, managed funds — and how much to invest in each category.

Historical Performance

Looking at historical data (since 1928):

U.S. shares: Average return of 11.5% per year
Bonds: Average return of 4.87% per year

This large return gap illustrates why asset allocation matters more than even the best security selection. Even the greatest bond picker may not beat the long-term returns of a basic equity index fund.

Conclusion

Asset allocation is the cornerstone of your investment success. Set it deliberately and use it as the foundation for selecting individual investments. It provides the structure and discipline to stay aligned with your goals, even as market conditions change.