The importance of asset allocation

the importance of asset allocation

The Importance of asset allocation

By Wouter Fourie (CFP®)
Director of Ascor® Independent Wealth Managers and the Financial Planning Institute of SA (FPI). He is an award-winning certified financial planner of the year 2015/16

 

Asset allocation has a major influence on whether you meet your financial goals, impacting your ability to build wealth and provide for retirement.

 


With thousands of shares, bonds and unit trust funds to choose from, picking the right investments can be confusing. But if you don’t do it correctly, you can find yourself saving and investing and still undermine your ability to build wealth and a nest egg for retirement.

 

Beating Inflation

Inflation will impact on you in both the build-up stages and, more particularly, in retirement. While it is clear that you need to start saving early, you also need to be sure that you are accumulating your retirement wealth at a rate that is greater than inflation. This means that the R100 you have and spend today will not be worth R100 in 10 years’ time. In simple terms, if your investment returns (after costs and tax) don’t outperform inflation, you can save yourself poor. Keeping up with and outperforming inflation should be your priority when investing. Outperforming the inflation rate is known as the real return of an investment.

 

Asset Allocation

Asset allocation is one of the most important decisions that investors make. Investments are conventionally divided into five asset classes: cash, bonds, equities, property and exotics (e.g. collectibles such as art and jewellery). The different characteristics of the four main asset classes make them suitable for different investment objectives:

■ Cash (including money markets and fixed deposits) is considered a short-term investment with a low risk level. One problem is that these investments offer very low or negative real returns. While the balance on your account might be increasing, you are losing money in real terms.

■ Bonds (long-term debt instruments) are considered medium- to long-term investments and carry a relatively high degree of risk. A safer form of bonds would be something like RSA retail bonds.

■ Property (residential and listed property funds) is considered a long-term investment with its own unique risk. Investors are faced with several options when it comes to property funds and it has a major influence on whether you meet your financial goals, impacting your ability to build wealth and provide for retirement. The importance of asset allocation is important to understand the differences between the types of funds, i.e. a property unit trust (PUTs) and real estate investment trusts (REITs).

■ Equities (shares in companies) are generally considered long-term investments with a degree of high risk over shorter periods. Equity-based investments are the most volatile asset class; the value of investments rises and falls according to the prevailing market conditions. Historical analysis, however, indicates that returns on equity investments have been superior to any other class of investments over the long term. The graphic shows the different asset classes with their historic real returns and the risk per category.

 

INVESTMENT ASSET TYPES RISK AND RETURNS
Figure 1: INVESTMENT ASSET TYPES RISK AND RETURNS

 

Asset allocation is important because it has a major impact on whether you will meet your financial goals. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goals. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in equity, for instance, would be inappropriate for a short-term goal, such as saving for a family summer vacation, while investing only in cash over a long time will leave you poor at retirement.

 

To illustrate the effect of asset allocation, let us consider two portfolios: a money-market fund and a multi-asset: high equity portfolio. Although money markets, as in 2016, might outperform equity over short periods, equity will be the superior performer over longer terms (seven years plus).

 

An upfront investment of R1m in a money-market portfolio (100% cash exposure; estimated total expected return of 1%) will leave you with about R1.16m in 15 years’ time. In contrast, a multiasset portfolio (75% equity, 10% property, 10% bonds, and 5% cash, with a total expected return of 5.95%) will be worth an estimated R2.38m in 15 years’ time.

 

In simple terms, if your investment returns (after costs and tax) don’t outperform inflation, you can save yourself poor.

 

Conclusion

Some financial experts believe that determining your asset allocation is the most important decision you’ll make with respect to your investments – even more important than the individual investments you buy. I must emphasise that there is no simple formula that can find the right asset allocation for every individual – if there were, I certainly wouldn’t be able to explain it in one article. With that in mind, you may want to consider asking a certified financial planner to help you determine your initial asset allocation and suggest adjustments for the future.

 

Related topics:

https://ascor.co.za/choosing-the-right-retirement-annuity/

https://ascor.co.za/investing-in-retirement-funds/

Follow us!
FacebooktwitterpinterestlinkedinFacebooktwitterpinterestlinkedin

Share this!
FacebooktwitterpinterestlinkedinFacebooktwitterpinterestlinkedin