Understanding Asset Classes

Financial Autonomy - Blog
Understanding Asset Classes

In financial planning, and particularly in portfolio construction, consideration of asset classes is absolutely foundational. But are we all on the same page when it comes to asset classes? When I use that term, are you thinking the same thing as me?

This week I’m going to take you through everything you need to know about asset classes to ensure that your understanding lines up with what I mean, and what others in the industry intend. This is the sort of thing that would be covered in any Investments 101 type course. Indeed, I discuss some of these concepts in chapter 5 of Financial Autonomy – the money book that gives you choice.

 

Let’s kick things off with some definitions. From the perspective of an Australian Investor, there are six primary asset classes. They are:

  1. Australian shares
  2. International shares
  3. Property
  4. Australian fixed interest
  5. International fixed interest
  6. Cash

You can divide some of these asset classes up into sub-categories, for example property could be split between residential and commercial, either of the share asset classes could be split up between large cap and small cap or value and growth. And then there are asset classes like “alternatives”, which is a bit of a bucket for investments that don’t fit in any of these mainstream categories.

But for the most part working with these six categories is sufficient.

Each of these asset classes has particular characteristics with regards risk and return. As you would know, risk and return are inextricably linked. If investment “A” has a higher return than investment “B” then you know that investment “A” must also have a higher level of risk than investment “B”. That rule just never breaks down.

Of these six asset classes, the first three, being Australian shares, international shares, and property, are considered growth assets. That is, their value will grow overtime. The last three asset classes, Australian fixed interest, international fixed interest, and cash are considered defensive assets. That is their strength lies more in protecting the value of your assets. In portfolio construction, the starting point is always your allocation between growth assets and defensive assets.

You will have come across this in your Super fund. The default might be the balanced fund and depending on the fund you are in, that might mean for instance 60% growth assets, and 40% defensive assets. If you wanted to chase a higher return, you might choose to go up to the growth option, which might have an allocation of 80% growth assets in only 20% defensive assets. Still not enough for you? Shift to the most aggressive option which is perhaps 100% growth assets and no defensive assets.

This is where an understanding of asset classes is so important. You need to understand where your money is invested and what that means for both risk and return.

Let’s take a closer look at the growth assets. Here we have Australian and international shares, and property. Of these, international shares are considered the most aggressive and therefore the most risky. It’s not that shares is located in another country are inherently more risky than those located in Australia, however when you invest in international shares you take on not just the volatility of international share markets, but also the volatility of the Australia dollar exchange rate. In truth, I tend to consider the level of risk in both Australian and international shares to be pretty comparable, and certainly a combination of both is less risky than holding exclusively one or the other.

Both these asset classes have great growth characteristics, whilst also providing some income. Of course that income can always be reinvested so as to generate compound growth as well.

Property is the third growth asset class. This is typically considered a little less risky than shares. Theoretically property is less volatile because rental income is pretty steady. The complicating factor is that property investments often entail gearing, ie. borrowing, and as covered in past episodes, we know that borrowing magnifies risks. So whilst it’s true that an ungeared property investment is lower risk then a share portfolio typically, once you add gearing in, that might not be the case. I should comment here that when we’re talking about property, we’re talking about things like a property trusts, the sort of thing that you’re Super fund might hold. I’m not talking here about individual residential properties where the risk is of course far higher because there is concentration in a single asset and a single tenant.

If your goal is to grow the value of your investments, particularly if you have a multi-year time frame, then it’s likely you would have a high weighting in your portfolio towards these growth assets.

The other side of the ledger are the defensive assets. These are your fixed interest holdings, and cash. These are your conservative holdings, whose role is primarily to preserve your capital. In some cases they may also be held to generate predictable income, something that may be especially relevant for someone in retirement. Again, international fixed interest is considered slightly more risky than Australian fixed interest due to exchange rate fluctuations, although very often local fund managers will take out hedging, a form of insurance, to mitigate this risk.

Asset Classes and your Investment time frame

When we build investment portfolios for clients, the starting inputs are investment timeframe and objective. For someone with a long timeframe, seeking growth in the value of their investments, we are likely to recommend a portfolio with a heavy bias towards shares and perhaps property. In some ways, this scenario is the most clear cut. But what about someone who seeks growth but only has a three year timeframe? Here, being heavily tilted towards growth assets is likely to be too risky. We know that shares suffer negative returns roughly one in five years, and should one of those negative years occur in a total investment period of three years, there is the potential for an investor to have less at the end of their investment period than they had at the beginning. Someone with this sort of timeframe then, even though growth is their objective, may need to hold some defensive assets to reduce the potential for a loss. In this scenario they might require a portfolio which is 60% growth assets and 40% defensive assets for instance.

Another interesting challenge that we see often is someone whose natural inclination is to be risk averse, yet their time frame is long. This could be the 30 year old looking at their super and deciding to put it in the conservative option. Or it could equally be the retiree who can’t stomach the idea of any volatility in their balance because in their mind that implies a loss, and this is the money they need to live off for the rest of their lives.

In both cases, a greater weighting to growth assets is the technically correct solution, and part of my role as a financial planner is to take people through this discussion. It may still be that in either case a significant weighting to defensive assets is appropriate. A portfolio that delivers a great return on paper, but keeps the investor awake at night worrying about their money, is not a successful portfolio.

It can be helpful in these situations to highlight the impact of being too conservative. Just this week we did some work for a 32 year old client. We compared her long-term outcome were she to earn a 6% return or an 8% return. The time frame was over 50 years, and because it was such a long time frame, the extra 2% return more than doubled the wealth she had at the end of the period. Another way to look at this is that choosing the more conservative option and earning 2% less halved the amount of wealth that would be accumulated. The important takeaway here is that being more conservative, whilst it reduces volatility in your portfolio, comes at a cost, and over the long run that cost can be very significant indeed.

Once you finish listening to this podcast, log into your superfund’s website and take a look at the asset allocation of your fund. It’s very important to look under the hood. Descriptions like “balanced” and “growth” can be very misleading. For instance, one fund that we use for many clients is a growth fund which holds 70% growth assets and 30% defensive assets. Yet one of the major super funds in Australia has a balanced fund that, despite its name, is actually 76% growth assets – more aggressive than an alternate fund labelled “growth”. Unfortunately, simply looking at the label is unhelpful.

If you have a long timeframe, likely the appropriate allocation for you is a heavy weighting towards growth assets. Now that will mean some volatility and crucially it will mean that when markets drop, which they inevitably will, you need to be prepared to stay in there and ride those out. If you don’t believe you will be able to withstand the volatility, then step things back and increase your exposure to defensive assets. You’re trying to strike a balance here between the optimal strategy according to an Excel spreadsheet, which would say 100% growth assets, and what you know you can stomach in terms of the roller coaster that is stock market investments.

 

Well, I hope that’s armed you with some good knowledge around asset classes. It’s a piece in the investment universe that is often considered assumed knowledge and maybe it shouldn’t be. If you haven’t already picked up my book Financial Autonomy I encourage you to do so because in there we look quite a bit at this area and how you might build an investment portfolio to help you gain choice in life. Also, if you look at the Financial Autonomy website on the Learn page you will find several useful downloads that might help you make progress on your goals.

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