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Investing | Spread it around

Zoë Fielding

How you distribute your money will have a big impact on your portfolio’s performance.

You can’t win all the time. No matter how good you are at picking stocks or funds or property, some investments just won’t do so well. Even in cash, Reserve Bank rate cuts will eat into your returns.

Careful research should help you win more often than you lose, but it’s inevitable that at some stage a portion of your investments will return less than you expected them to – or worse still, will go backwards. The trick is to minimise the consequences of losing.

This is where diversification comes in.

Diversifying your portfolio involves spreading your money across different asset classes, such as Australian shares, cash, international shares, bonds and property.

The idea is that if one asset class falls in value the loss will be compensated for by gains in another, unrelated, asset class.

The way you allocate your funds between growth-oriented and income-generating assets has a major effect on the portfolio’s performance.

It’s important to get it right.

Just when investors thought they were safe by diversifying, the GFC came along and threw up a huge problem – ‘sequencing risk’ – which shows that the order of returns an investor achieves is ultimately incredibly important and could even cost millions of dollars. Source: FINSIA

The philosophies

There are various schools of thought on how to decide where to put your investments.

The executive general manager of advice at Commonwealth Bank’s wealth management division, Marianne Perkovic, says the most common philosophy is known as strategic asset allocation.

This approach starts with the investor’s appetite for risk – that is, whether they’re a conservative or aggressive investor or in between. Financial planners often use questionnaires to determine clients’ “risk profile”, based on their attitudes and experience with taking and tolerating investment risk. This allows them to apportion assets according to their risk tolerance.

A conservative investor’s portfolio would be dominated by cash and fixed interest, which tend to generate consistent returns. An aggressive investor’s portfolio would have a much higher weighting to growth-oriented investments such as shares or alternative assets, whose returns are likely to fluctuate more but should be higher over time.

A strategic asset allocation should be high level. It should talk about the proportion of the portfolio held in shares versus bonds, for instance, not about how much will be invested in Woolworths versus BHP Billiton.

One of the strengths (and weaknesses, but more of that later) of this approach is that it’s static and long term. “It’s easy to get caught up in market returns and market volatility but if you’ve got a time frame and a goal in mind, sticking to it usually ends up being the best strategy,” Perkovic says.

The “long term” in strategic asset allocation means 10 or 20 years, State Street Global Advisors’ (SSgA) head of investments for Asia-Pacific, Lochiel Crafter, says.

“The trouble with that is that nothing stays that stable for that long,” he says. “Nothing ever delivers exactly what you think it’s going to deliver over 20 years.”

Talk tactics

The static nature of strategic asset allocation can be a shortcoming. But over time, there may be opportunities to alter the asset allocation to suit the prevailing market environment. Particular assets might become over- or undervalued and the investor might want to hold less or more of those assets.

Making minor adjustments to a portfolio like this is called dynamic or tactical asset allocation. It’s all about small, detailed movements. “When we move we’re moving 2 to 3 per cent at a time, not 10 or 20 per cent,” says Kieran Canavan, who sits on Centric Wealth Advisers’ investment committee. “The only time we may . . . move heavily out of particular areas is if we’re very concerned about a bubble in that particular area.”

At the start of 2012, Centric’s investment committee weighted its share portfolios towards Australian real estate investment trusts, believing them to be undervalued. Now they’ve moved back to a neutral weight, having taken profits from the 30 per cent upswing in A-REIT values.

“We have neutral positions where we believe the asset is at fair value and then we might swing towards or away from markets that we think are over- or undervalued,” Canavan says.

SSgA’s portfolios also have lower than normal allocations to fixed income, which has been a popular asset class but now looks overvalued to the manager. It has slightly overweight allocations to equities and other growth-oriented assets. How often you vary your allocation is a personal choice – but this is not day trading. SSgA’s managers review their positions every month.

But be careful. Tactical asset allocation isn’t easy. It’s not about chasing returns. Crafter says tactical calls are not just about markets, they’re also about cash flow, tax and a range of other factors the individual investor needs to think about. Unless you have a lot of time and energy to dedicate to research, it might be best left to the experts.

A personal touch

The main downfall of both strategic and tactical asset allocation is that these approaches ignore how risk applies to each person. Professionals and academics are only starting to understand just how “individual” investment risks can be.

In the 2008-09 global financial crisis, shares, bonds, commodities and property all lost value as investors panicked when big-name US banks collapsed. Central banks, responding to the crisis, slashed interest rates, cutting returns on cash. “The only thing that went up in the financial crisis was correlation [between assets],” says Michael Drew, professor of finance at Griffith University’s business school.

Even investors who had their money spread across different asset classes suffered losses. Everyone felt the pain, but the consequences of the losses varied. “If you’re 35 and there’s a GFC event, you have a small amount of money and, while it’s painful, you have 30 or 40 years to make up any losses,” Drew says. “If you have a GFC event when you’re 58, this can be equivalent to 1.5 times your lifetime contributions to super and can mean a substantial decline in the annuity income value of your retirement stream.”

The GFC highlighted a big risk that no one had thought much about before: “sequencing risk”. It showed how the sequence or order of returns an investor achieves is incredibly important to the ultimate outcome.

Drew and colleague Anup Basu, from Queensland University of Technology, analysed the results if someone had invested in a fairly typical balanced portfolio, with 66 per cent in growth assets and 34 per cent in income assets. They assumed the portfolio achieved the actual market returns experienced between 1972 and 2011.

Annual returns through that period ranged from a 42 per cent gain down to a 22 per cent loss. The average return over the 40 years was 12 per cent and the standard deviation (the volatility of the returns) was 15 per cent.

The researchers assumed a zero starting balance, a starting salary of $41,552, increasing by 4 per cent a year, and 9 per cent super contributions. After 40 years, the portfolio was valued at $4 million.

Next, they reversed the order of the returns. The average return was still 12 per cent and the volatility was the same. But this time, at the end of the 40 years, the portfolio was worth $5.4 million, simply because the bigger percentage gains came towards the end, when the balance in play was larger.

They repeated the exercise, assuming the returns came in ascending order – with the worst losses at the start when the balance was smallest and the best gains made when the portfolio was at its largest. In that case, the portfolio was worth a whopping $15.4 million after 40 years, despite the average return being the same.

If the returns were placed in descending order – the best returns first and the worst last – the portfolio was worth $1.4 million at the end, or $14 million less than in the opposite sequence. “It really makes you think about risk as something more than deviations from what you’d expect,” Drew says.

“It makes you think about risk in a way that’s more meaningful to investors and individuals – which is, what’s the probability of not meeting the objective, target or outcome we’re trying to achieve. That leads to thinking about different stages of life and how what’s risky and what’s safe changes throughout your life.”

Fresh approaches

Some super funds are toying with a solution to sequencing issues by considering an investor’s age when determining asset allocation. Such life-cycle investing is popular in the US and is gaining favour here. With this approach, the asset allocation for younger investors is typically quite aggressive. The theory is that young people can afford to take more risk because they have time to recover from losses.

As the investor moves towards retirement, the asset allocation shifts towards more defensive assets. The weighting towards defensive assets changes automatically on the person’s birthday. That stops older investors taking too much risk as they approach retirement – and younger investors not taking enough – but it doesn’t take into account individual needs or preferences.

“There’s more than just the retirement date that’s important here,” Drew says. “It’s human capital, it’s wealth in and outside of super, it’s ownership of the family home, it’s longevity risk, life expectancy, the kind of lifestyle you want in retirement.”

Recognising that everyone is different, some investment advisers are focusing first on the outcomes the investor wants to achieve and then building a portfolio that aims to meet those objectives. This system divides the total pool of money and invests each part differently, depending on what it will be used for and when.

Ipac’s head of advice and strategy, John Dani, advocates this method, emphasising the importance of having cash available when it’s needed. “If an investor recognises that they have to draw down their wealth, we recommend that the next two to three years of their income be allocated to cash or cash-based investments,” Dani says.

For a retiree who has $500,000 to invest and requires an income of $30,000 a year to supplement Centrelink benefits, Dani would suggest allocating about $90,000 to cash and using that for short-term withdrawals. Someone who’s still working probably wouldn’t need so much cash.

The next step is to look ahead three years and to defensive assets with a higher growth profile than cash. “After you’ve allocated to cash and defensive assets, the rest can then, with a degree of security, be allocated to more growth-oriented assets,” Dani says.

For this approach to work, the cash allocation must be topped up from time to time and the portfolio brought back into balance. Dani recommends reassessing the situation every six to 12 months.

When markets are performing well, skim off some off the growth component and take the opportunity to top up the cash holdings, he says. When markets are not so good, defer this to avoid crystallising losses.

The strategy aims to mitigate sequencing risk by creating a buffer of six years’ income before the investor would have to dip into any long-term assets. That should reduce the likelihood of being forced to realise losses in the growth portion of the portfolio.

Investors who find they have some spare cash during market downturns might even take advantage of reduced asset prices to buy back into shares, Dani says.

Centric Wealth adviser Cherie Feher also recommends basing the asset allocation on the investor’s goals. She starts by asking clients about their aims and time frame, and how far they are from achieving them.

Long-term requirements, such as having a certain income in retirement, will be matched with a different exposure to growth and defensive assets than short-term goals such as buying a car in the next year or so.

“It would be inappropriate to invest the cash in something highly speculative and highly risky such as geared investments or geared warrants where the money may be worth heaps or it may be worth nothing in one year’s time,” Feher says. “There’s no ability for the client to ride out the weather.”

Feher asks clients about their attitudes towards risk but uses that as an overlay after concentrating on their goals. “There’s no point taking an aggressive stance and buying volatile long-term investments if you’re going to freak out and want to sell as soon as those investments drop,” she says. “That’s really going to do damage to the strategy. Maybe you’re better off lowering your expectations.”

Timely reviews

Whatever method you use to allocate your assets, it’s a good idea to review your portfolio every year. Life changes or experiences may make you more or less risk averse. Your goals will change. As you change, so should your portfolio.

But be honest with yourself. Has your appetite for risk really changed? Can you really stomach extra risk over the next decade or more? Or are you simply feeling more comfortable about how markets have performed this year? How would you feel if markets crash again?

Equally, if you’re planning to lower the risk in your portfolio, ask yourself whether it’s a knee-jerk reaction to short-term volatility. Will you have regrets if markets boom or will you be content with a steadier ride?

If you’re bringing your portfolio back to the balance you set in your asset allocation, make the change all at once, Dani says. It’s about having a predetermined amount in cash and other assets and it’s important to maintain discipline.

Otherwise, move slowly, gradually shifting money in and out of the market in a series of transactions spaced out over weeks or months. That reduces the possibility you’ll sell or buy everything just at the wrong time.

If you’re losing sleep during a downturn because you’re taking too much risk, Dani says withdraw gradually to avoid missing a recovery. He suggests starting to plan for retirement about three to five years out, giving you time to build a cash buffer.

And don’t forget about tax. If you’re heading for retirement, consider selling assets only after you’ve started an allocated pension so there’ll be no capital gains tax.

Try to realise capital gains in tax years when your income is lower. Use any losses as quickly as possible, as they’re not indexed and therefore lose value in real terms over time. When gradually shifting in and out of markets, consider straddling tax years.

“But first you need to think about what the investment will do,” Feher says. “You’d hate to delay it for a tax reason and then the markets move against you, eroding your tax advantage with an investment loss.”

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