The perfect investment mix

Today’s Say What Wednesday question is from Linus. Linus asks, ‘I was just wondering what you think the ideal weighting of Australian (ASX200) ETFs, similar international ETFs and Bonds is in an investment portfolio? Love the show, thanks.’

There’re a few things to cover off here!

The ideal weighting of Asset allocations; that is, how much you have allocated to Australian Shares, to International shares, to Bonds, etc.

To determine the ideal weighting there are 3 questions that need to be asked:

1. What is the purpose of the investment portfolio? What are you trying to achieve?
   • Long term growth – Trying to maximise the balance
   • Short term stability – Well diversified portfolio with low exposure to growth
   • Drawing an income or reinvesting – which determines the type of investment held
2. How much time do you have?
   • Longer timeframes allow for more planning and take advantage of long term growth
3. How much risk do you need?
   • Returns come in two parts = Income + Growth
   • If there is growth in the equation, the investment can lose value – this is where risk comes in.
     But, it can also help long term.

Portfolio construction – What you need to know

1. Which asset classes you need?
2. How much should you allocate to each of these asset classes?
3. Which investments should you choose within each asset class?

No. 1. Asset Classes
Selecting the correct mix of Income and Growth

1. Five main asset classes – the core to most portfolios (doesn’t include direct property)
   • Each has their own purpose
   • For example, if you need to draw a consistent income, you won’t want much volatility
2. Defensive (No growth) – Low chance of capital loss, don’t increase or decrease in value over time
   • Cash – earns interest
   • Fixed Interest – receives coupon payments (receive the Face Value back at the maturity)
3. Growth – Has chance of capital loss (riskier)
   • Australian Shares – Dividends and Price gains (generally higher dividends than International shares)
   • International Shares – Dividends and Price gains
   • Listed Property and Infrastructure – Dividends and Price gains

No.2 Risk profile

To determine the allocation to each class, you need to determine your capacity to deal with risk.

The traditional way – Risk Profiles (which provides an outline but is not a perfect science). These help to get an idea about how much growth is acceptable.

1. High Growth – 100% to Growth investments like shares and property – Longer term 8+ years
2. Growth – 80% to growth – Longer Term – 7+ years
   • Cash, Fixed Interest of 20%
3. Balanced – 65% to growth – Min timeframe of about 6 years
   • Cash, Fixed Interest of 35%
4. Conservative – 50% growth
   • Cash, Fixed Interest of 50%
5. Defensive – 30% growth – Good to minimise volatility, shorter term investments or those from which you’re drawing an income
   • Cash, Fixed Interest of 70%

No.3 Selecting the investments within each asset class

1. Defensive
   Generally for either income or capital protection
   • Cash – How much income do you need? Do you have a need for reserves?
   • Fixed Interest – Australian or International. Credit, Alternatives, or Bonds
     • Higher risk (e.g. Corporate debt) – higher yields
   • Growth
     • Australian Shares – Market caps – Selecting a good weighting between asset classes
       • ASX200 – Large Cap allocation
       • Small cap ETFs – Issue is when they are passive
     • International Shares – different countries and market cap

Balancing your desired return with how much risk (volatility) you can afford

1. Risk – Volatility – Potential movements in price around a mean average
   • High potential for movements, considered higher risk
   • Speculative risk – Can become absolute risk (i.e. losing everything) but can be avoided through proper diversification (which is the whole point of asset allocation)
2. Returns – The higher the levels of volatility, the higher the expected return should be
   • Risk-return relationship – Less invested in assets that can lose value, lower the allocation to assets that don’t grow in value
   • If something can’t gain value, it is harder for it to lose value

Back to Linus’ question: Ideal Weighting / Perfect allocation

1. What is the purpose, timeframe and return needed?
   • Example #1 – purpose is to invest for the long term to maximise wealth, investing every few months
     • You are tolerant to risk (not spooked out by volatility) and have about 20+ years to invest, plus you’re going to make ongoing investments
     • Allocation – Growth to high growth may be appropriate. For example, 0-20% Fixed interest (cash can be minimised)
     • Allocation: 20% to FI, 20% to LargeCap Aus shares, 10% to MidCap Aus shares, 10% to Smallcap Aus shares, 20% to LargeCap International shares, 10% to Emerging Market International shares, 10% to Infrastructure
     • What this is looking to achieve – Large long-term returns, leverage volatility to take advantage of ongoing investments, have best chance of maximising the balance
2. Example #2 – Purpose is to invest to generate a passive income with minimal volatility
   • Pretty scared about volatility, you want to achieve a better income return than your cash, but don’t want to see portfolio drop more than 15%
   • Allocation – Conservative – Over 50% Defensive (depending on timeframes)
   • Allocation: 20% to Aus Fixed Interest, 30% to Int Fixed Interest, 15% cash, 30% to Aus shares – mostly large cap, 15% to International shares – again, mostly large cap
   • What this is looking to achieve – Greater return than cash, likely to not drop below 15% loss overall

Conclusion – First just ask what the purpose of the investment is

1. What you will need out of the investment?
   • Growth, stability, income? – Determines the Income/Growth Relationship
2. What investment mix will achieve this? i.e. how much to growth or defensive (Risk profiles)
   • Long term high growth – Greater amounts to growth investments
   • Capital stability – More in to investments that don’t lose much in value historically
3. What allocation within each asset class is needed?
   • Fixed Interest – High yield or safe AAA rated bonds
   • Shares – Emerging markets or allocation to smaller cap allocations
4. Does this suit my risk tolerance?
   • Yes – Good allocation
   • No – Do I need to accept the additional risk? There’s more than one way to skin a cat

Thanks for the question Linus!

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