Most people think that to invest successfully, you have to pick the right stocks or properties and watch them rise in value. While you certainly need as many of your investments as possible to rise, it’s how you spread your investment portfolio around that has the most effect on your wealth.
Academic research consistently shows that the asset allocation of a portfolio (apportioning it among different asset classes) plays a much bigger role in a portfolio’s performance than the individual assets chosen for it. The asset allocation of a portfolio typically accounts for about 90 per cent of the investment performance on a risk-adjusted basis.
Asset allocation seeks to balance risk and return. As the potential return of an investment rises, so does the level of risk being run, and so does the level of uncertainty of the outcome. The paradox of risk is that an investor can only make the high returns essential to creating wealth by running relatively high risk. But diversification offsets this risk.
What you are essentially trying to achieve with diversification is to pick up different sources of return to maximise the likelihood of the portfolio increasing in value, while at the same time trying to lessen the overall risk of the portfolio by increasing the chance of at least some portion of the portfolio performing well -- even if most of it is down.
Every investment in a portfolio should either be a source of return or have a diversifying effect, away from the main component of the portfolio, which is usually shares.
The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk -- your ability and willingness to lose some or all of your original investment in exchange for greater potential returns.
The basis of portfolio construction is that the growth assets, shares and property, are the cornerstone assets to build wealth. Income-generating assets like bonds provide the income later in life. Shares certainly do the heavy work of generating wealth through the power of compounding returns. But even a portfolio set on full wealth-building mode should contain bonds because they move in a different cycle to shares.
Consistently, over one year, five years and ten years, Australian bonds show a negative correlation with shares, meaning their returns do not move in lockstep. That makes combining bonds with shares a very simple diversification strategy. Lack of correlation is the key to diversification: price movements in one asset in a portfolio can counteract price movements in another asset, but investors have to remember that asset-class correlations are not set in stone. Uncorrelated returns -- that is, returns not correlated to shares -- are extremely important to professional investors.
That is why bonds play a major role in Australian superannuation portfolios, which are long-term portfolios that are built to be diversified. The fixed-income component of an investment portfolio generally represents the safer and less volatile portion of the portfolio, as well as a strong diversifying asset.
Given the massive growth in super fund membership in the last 20 years, the focus of the Australian super industry has mainly been on capital growth, the ‘accumulation’ phase. The great retirement wave of the baby boomers, which will make the “drawdown” phase more important, is not yet in full swing.
In addition, Australia’s system of dividend imputation makes shares very tax-effective in superannuation. The combination of shares’ strong track record in wealth creation and tax-effective income streams through dividend imputation makes Australian shares the cornerstone investment of Australian super.
For these reasons, Australian super is heavily weighted to shares. According to the Australian Association of Super Funds, the asset allocation of Australian super funds’ balanced options -- the ‘default’ strategy, where about 80% of Australians have their super invested -- is as follows.
% of assets
However, the fact that Australian institutional super portfolios are so heavily weighted toward shares causes plenty of debate in the industry and surprises overseas observers, because Australia is greatly out of step with overseas thinking on pension funding.
In its Pension Funds in Focus report in July 2011, the Organisation for Economic Co-operation & Development said that in most of its member nations, bonds (not shares) were by far the dominant asset class, accounting for an average of 50 per cent of total assets. In the asset allocation of its retirement income system, Australia -- along with the United States, Finland and Chile -- effectively operates the mirror image of the ‘norm’ of other OECD pension systems.
This is even more stark in the case of self-managed super funds, which have grown to hold almost $560 billion worth of assets: the largest single slice of the superannuation pie. According to the Australian Taxation Office SMSF statistics at March 2014, Australian shares, cash and direct property represented a massive 76 per cent of all SMSF investments.
In sharp contrast, SMSFs hold a bare 0.8 per cent of their assets in bonds. They are missing a very important diversifying element.