Understanding asset allocation is vital, when it comes to advising clients and articulating the value of your advice.
Advisers are never more important than during periods of significant change. As the macro backdrop continues to evolve and volatility reigns, the need for advice and reassurance of clients is as imperative as ever. This article, proudly sponsored by Russell Investments, examines the value of advice and within that, the importance of appropriate asset allocation.
In a complex world that keeps posing challenges to investors, advisers continue to add value that enables their clients to attain their long-term financial goals. The spectre of a global recession, along with rising interest rates and inflation have created an environment of extreme caution in 2023, just three years after a global pandemic swept through markets to test investors’ fortitude.
In this environment, Australians have relied on their financial advisers heavily to navigate both the practical and emotional aspects of investing. Advisers have provided invaluable assistance, helping their clients to review their evolving goals, needs and circumstances in an uncertain environment.
This holistic wealth management requires a deep discovery process, planning and ongoing coordination, not always easy when clients’ anxiety runs high. As priorities and outlooks may have changed over the course of the pandemic and beyond, the adviser-client relationship has proved fruitful not just in periods when markets fell, but also when assets rose to buoy portfolio gains.
Those advisers who helped their clients remain invested through the turbulence, who helped them prepare for an uncertain future, who worked with them to determine their post pandemic goals, can look back with a real sense of having provided true value.
How then, can you best articulate that value? A recent paper[1] detailed the five factors that measure and provide true adviser value to clients:
- asset allocation
- coaching
- helping clients through choices and trade offs
- expertise
- tax savvy planning and investment.
This article will examine the first of these factors, asset allocation.
Under the spotlight: asset allocation
Asset allocation is a fundamental investment principle and serves as the cornerstone for achieving long-term financial objectives. It can be described as the strategic distribution of investor capital across various asset classes, which may include shares, fixed income, alternatives, real assets such as property and infrastructure, and cash. The significance of asset allocation lies in its ability to balance risk and return, thereby optimising the potential for each client to achieve their specific investment goals.
Appropriate asset allocation is a crucial aspect of a well-rounded investment strategy; it’s not just about maximising returns, but also managing risk. In this context, risk means volatility and the potential for fluctuations in the value of your clients’ investments.
Volatility can be unsettling for many investors, leading them to question their investment decisions and make impulsive decisions. Different asset classes have distinct risk profiles and, by spreading investments across multiple asset classes, an adviser can mitigate the impact of a severe downturn in any one area. If a portfolio is heavily concentrated in a single asset class, it becomes susceptible to extreme swings in value, potentially leading to significant losses. In contrast, a well-diversified portfolio is better positioned to weather market fluctuations.
Asset allocation is an important tool to align investments with an individual’s risk tolerance and their financial goals. A younger investor with a long investment horizon and a higher risk tolerance might allocate a larger portion of their portfolio to growth assets, which historically offer higher potential returns over the longer term. Conversely, an investor closer to retirement may opt for a more defensive allocation, with a greater emphasis on securities more likely to preserve capital and generate income.
Asset allocation enables advisers to capitalise on the benefits of different economic cycles, further adding value to their clients. Because asset classes often perform differently in varied economic environments, advisers can modify portfolios accordingly. By strategically adjusting the weighting of assets in response to economic conditions, advisers can potentially enhance the returns and reduce overall portfolio risk experienced by their clients.
Importantly, following a designated asset allocation approach allows for advisers to rebalance portfolio as required; this is crucial for maintaining each clients’ desired risk-return profile. Over time, original asset allocation can drift due to market movements. Being able to ensure a client’s portfolio stays aligned with clients’ objectives and risk tolerance is an important component of the value advice can add.
Asset allocation can also help advisers set realistic expectations. Different asset classes have historically delivered varying levels of returns. By understanding the historical performance of each asset class and the potential risks involved, advisers can establish realistic expectations for their clients’ investment outcomes. This knowledge forms the basis for setting achievable financial goals and helps to manage expectations during periods of market volatility.
Realistic expectations help advisers promote disciplined investing, so their clients avoid impulsive decisions driven by short-term market fluctuations or emotions. These reactions often occur at precisely the wrong times, typically when the market is experiencing a downturn. Instead of reacting to market noise, an allocation strategy can provide a framework for making informed investment decisions. This disciplined approach fosters patience and reduces the likelihood of clients making costly mistakes.
It’s not just volatile times that can prove challenging. During periods of prolonged market upswings, investors may become complacent and underestimate the significance of a professionally managed portfolio. In these times, self-directed investment portfolios can gradually deviate from their initial asset allocation. This deviation can be perilous, as it may expose the investor to higher levels of risk than they initially intended.
This is where disciplined asset allocation and rebalancing come into play. By regularly reviewing and adjusting the asset allocation, a well-managed portfolio can maintain its original balance of assets. This is crucial because it ensures that the portfolio remains aligned with the investor’s stated financial objectives.
Appropriate asset allocation
In bull markets, it can be easy to underestimate the value of a professionally managed portfolio. During these periods, self-directed investment portfolios often drift away from the initial asset allocation. A disciplined approach to portfolio management and rebalancing can ensure a portfolio retains its original asset allocation – and therefore remains appropriate for an investor’s stated goals – while also potentially reducing risk.
How an individual is invested has a huge impact on achieving their investment goals. Many non-advised investors believe market timing or investment selection are the greatest determinants of portfolio success…but they would be wrong. Rather, it is asset allocation that’s at the heart of every investment strategy, determining more than 85% of the outcome for an individual ahead of the selection of the actual assets within a portfolio[2].
This known investment truth is becoming even more apparent as the range of investment opportunities increases, encompassing asset classes that didn’t exist until recently and remain difficult for retail investors to access.
It is also, though, perhaps the most underestimated element of financial advice by the general public. Retail investors are more inclined to remember the returns of individual stocks – such as this year’s gains from the so-called magnificent seven AI stocks – than how asset allocation laid the foundation for overall risk-adjusted returns.
Analysis shows that carefully considered asset allocation, which takes into account the needs of an individual, can add value of up to 1.2% per annum[3].
Asset allocation: who benefits most?
There are generally two types of non-advised superannuation investor. The first category (case study one) is the disengaged investor, who either consciously or unconsciously opt for the one-sized-fits-many default options offered by their funds. By definition, these default options take limited – if any – account of personal circumstance or needs.
The second category are those engaged investors who build their own portfolios (case study two) but can sometimes find themselves falling foul of risks that they have not considered when allocating capital to different assets.
Case study one: The disengaged investor
More than 63% of the $996 billion in MySuper investments is allocated to single strategy options[4]. This means members, irrespective of age, super balance or retirement goals, are invested in the same way as everyone else.
This case study uses Jane as an example. Her adviser recommended an allocation of 80% to growth assets after conducting an analysis that considered her age, investment goals, superannuation balance and other preferences.
Her hypothetical portfolio could deliver an annualised return of 7.8% over a 10-year period, versus the 6.6% gain from a default superannuation fund with a 70% allocation to growth assets.
Her potential extra gain of 1.2% means her retirement savings could be worth $210,947 after 10 years – or $21,818 more than if she invested in a default portfolio.
Case study two: The self-directed asset allocator
There are inherent risks in a DIY approach to asset allocation that can limit investment returns, ranging from a lack of investment know-how to ill-discipline that prevents an individual from implementing a strategy and reweighting it as required.
The increasingly complex world of investing requires an in-depth knowledge of markets, economics and geopolitics that is difficult for individuals to both attain and maintain. Advisers can fill this gap by offering an insight into alternative assets which make up a larger part of institutional-grade portfolios than previously, such as private debt and infrastructure.
The above factors are reflected in Australian Taxation Office statistics which consistently show self-managed super funds (SMSFs) have a relatively high allocation to cash. The latest figures show SMSFs had a 16% allocation to cash at March 2023[5]. Such conservative asset allocations can hold investors back if they require capital growth to meet their retirement goals.
For example, Lee has a SMSF he manages on his own. It holds over 70% in cash and other defensive assets, even though an adviser may recommend that over half his portfolio should be in growth assets given his circumstances and objectives.
Indeed, Lee’s portfolio could deliver a hypothetical return of 4.3% over 10 years versus a return of 5.7% from a portfolio split equally between growth and investment assets. The significant difference of 1.4% could be reduced if Lee sought assistance from a financial adviser to determine the asset allocation best suited to his needs.
Based on an initial $100,000 balance, after 10 years Lee might have $152,936 in the more conservative portfolio versus a balance of $174,575 for the advised portfolio.
By investing in a DIY portfolio, Lee could be $22,000 worse off after a decade. In periods of steadily rising markets, it can be easy for people to underestimate the value of a professionally run portfolio. The danger, however, is that a DIY allocation will drift away from its initial position.
A more disciplined approach to portfolio management by advisers can ensure the original intent is maintained and the asset allocation remains appropriate for an investor’s stated needs.
Appropriate asset allocation is about far more than simply chasing high returns. It’s about crafting a strategy that safeguards against unnecessary risk and aligns with your clients’ financial goals. Through diligent portfolio management and regular rebalancing, advisers can maintain this alignment, potentially reducing risk and increasing the likelihood of achieving their clients’ long-term financial objectives.]
