What is the role of asset allocation when it comes to adding value to clients?
While financial advice is always important, it’s especially critical during periods of market volatility in a world with a plethora of geopolitical uncertainty. This article, proudly sponsored by Russell Investments, examines the value of financial advice and within that, the importance of appropriate asset allocation.
Advisers continue to provide clients with advice that enables them to achieve long-term financial goals in a constantly changing and complex world.
In 2024, that has meant balancing the competing emotions triggered by strong investment returns and a cost-of-living crisis. While we’ve seemingly avoided the global recession that was predicted this time last year, pervasive sticky inflation, an uncertain interest rate environment and periods of market volatility amid the positive returns have made investors nervous. Advisers have played an important role, to encourage clients to stick to their long-term goals in this environment by providing both practical and emotional guidance that allows them to navigate the highs and lows of wealth generation.
Advisers’ counsel helped their clients adhere to principles such as asset allocation by reweighting portfolios as stock markets reached new highs. Equally, it has encouraged clients to retain dollar cost averaging even as household budgets are squeezed by rising prices.
For younger generations, advice has helped them make the multitude of decisions required to enter the housing market, start families and pay off HECS debts. Older people have been better able to plan for retirement and their own parents’ aged care by engaging advisers.
Of course, financial advice encompasses so much more than investing. It requires in-depth knowledge of taxation, superannuation and social security, plus the understanding of human behaviour required to support people making life decisions.
Holistic financial advice requires a deep discovery process, planning and ongoing coordination. This is particularly challenging when uncertainty prevails and clients’ anxiety runs high. Clients’ priorities, goals and outlooks may have changed during this time, making the adviser-client relationship more important than ever.
Those advisers who help their clients prepare for an uncertain outlook and remain invested through periods of market uncertainty, who work with closely with their clients to ensure they can achieve their goals – or important milestones towards those goals – can look back with a real sense of having provided true value.
How then, can advisers best articulate that value? A recent paper[1] examined the five factors that measure and provide true adviser value to clients:
- asset allocation
- behavioural coaching
- choices and trade offs
- expertise
- tax savvy planning and investment.
This article will examine the first of these factors, asset allocation.
Asset allocation examined
Asset allocation is a core principle of investing and plays a critical role in enabling clients to achieve their short and long-term financial goals. It refers to the strategic division of an investor’s capital across various asset classes, such as equities, fixed income, alternatives, real assets and cash. The key importance of asset allocation lies in its ability to balance risk and return; this optimises the likelihood that each client will achieve their specific investment objectives.
A well-planned asset allocation strategy is essential for a comprehensive investment approach; it focuses not only on maximising returns but also on managing risk. In this context, risk refers to volatility, which signifies potential fluctuations in the value of investments. Volatility can be unsettling and can often lead investors to question their strategies and make impulsive decisions.
Because each asset class carries a different risk profile, diversification across multiple asset types helps mitigate the impact of severe downturns in any one sector. A portfolio heavily concentrated in a single asset class is vulnerable to large swings in value, which could result in significant losses. In contrast, a well-diversified portfolio is better equipped to handle market volatility.
Asset allocation plays a vital role in aligning investments with each clients’ risk tolerance and financial goals. For example, a younger client with a long time horizon and higher risk tolerance might allocate a larger portion of their portfolio to growth assets, which tend to deliver higher long-term returns. Conversely, a client nearing retirement may prefer a more conservative allocation, focusing on assets that preserve capital and provide income.
Advisers can also use asset allocation to take advantage of different economic cycles, adding further value to clients’ portfolios. Since asset classes often perform differently under varying economic conditions, adjusting the portfolio’s composition in response to these changes can enhance returns and reduce overall risk.
Another important aspect of asset allocation is rebalancing. Over time, as market conditions shift, a portfolio’s original allocation may change. Regular rebalancing ensures that the portfolio stays aligned with the client’s objectives and risk tolerance, maintaining the desired balance between risk and return. This is a key element of the value advisers provide, helping clients remain on track toward their financial goals.
Asset allocation also allows advisers to set realistic expectations for investment outcomes. By understanding the historical performance and risks of different asset classes, advisers can help clients establish achievable financial goals. This knowledge is critical for managing expectations during periods of market volatility and promotes a disciplined investment approach.
Managing client expectations also helps reduce emotional, short-term decision-making. During market downturns, impulsive reactions can lead to costly mistakes, often at the worst possible time. A thoughtful allocation strategy provides a framework for making informed decisions based on long-term objectives, rather than reacting to market noise.
It’s not only during volatile times that investors face challenges. In prolonged market upswings, complacency can set in, leading self-directed investors to drift from their original allocation and expose themselves to higher risks than they intended. Regular reviews and adjustments to the asset allocation help maintain the right balance and ensures the portfolio remains aligned with the investor’s long-term goals. This disciplined approach, combined with periodic rebalancing, is essential for managing risk and achieving financial success.
Appropriate asset allocation
How an individual is invested has a huge impact on their ability to achieve 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. Instead it is asset allocation that’s the biggest weapon in an investor’s arsenal, as it accounts for more than 85% of their ultimate outcome. It far outweighs the impact of individual security selection[2].
This is becoming increasingly apparent as the number and types of investment opportunities increase, encompassing asset classes that weren’t previously available to retail investors. This includes rejuvenated cryptocurrencies, which are now more accessible through spot exchange traded funds, and the growing private debt market.
The latter’s recent boom has driven a proliferation of providers with sophisticated marketing, though the average investor’s understanding of private debt remains limited and good advice is critical to achieving desired outcomes.
Nonetheless, the importance of asset allocation is underestimated by the general public. Retail investors are more inclined to remember the returns of individual securities than how asset allocation laid the foundation for overall risk-adjusted returns.
The thrill of stocks reaching new peaks in 2024 – including AI giants like Nvidia and local stalwarts like Commonwealth Bank – may have proved sufficient for many investors to abandon caution in the belief that “it’s different this time” and resist moves to rebalance their portfolio.
But these are the very investors most likely to panic in rapid market retreats. It may seem counterintuitive, but the guidance of an experienced adviser is just as critical in rising markets as down times.
Asset allocation in action
There are generally two types of non-advised superannuation investor who can benefit from professional asset allocation advice.
The first is the disengaged investor, one who consciously or unconsciously opts for the one-size-fits-all default option offered by their super fund for simplicity’s sake. By definition, these default options take limited – if any – account of the personal circumstances or needs of an individual.
The second category is comprised of engaged investors who build their own portfolios but sometimes fail to consider all the potential risks – or even all of the opportunities available to them.
The following case studies examine both categories of investor. In each case, professional advice could help prevent the investors from generating lower gains that place them behind others in their retirement planning.
Case study one: The disengaged investor
The majority of Australians hold their super in default options. These options take no account of their age, super balance or retirement goals. More than 62% of the $1 trillion in MySuper investments is allocated to these single strategy options[3].
This high level of disengagement means investors often miss out on the opportunity to improve their financial position with personalised strategies. This case study considers Maryanne, who – until recently – had been a disengaged investor. Her retirement plans received a boost after she sought advice, and her adviser recommended that she allocate 80 percent of her super to growth assets. This recommendation was based on an analysis that considered her age, investment goals, risk tolerance, superannuation balance and other preferences.
Maryanne’s new portfolio could deliver an annualised return of 7.4 percent over a 10-year period. By contrast, her previous default super option, which had 60 percent in growth assets, might return a lower gain of 6 percent. Maryanne’s potential extra gain of 1.4 percent could translate into $204,956 after 10 years – nearly $26,000 more than if she stayed in the default portfolio.
Case study two: The DIY asset allocator
A DIY approach to asset allocation has potential pitfalls if an investor lacks the know-how or discipline to keep their strategy on track over the long term. This includes rebalancing the portfolio, particularly during a bull market when returns might seem too good to be true.
This is especially pertinent in a world in which market complexity is amplified by geopolitics and economic uncertainty. Advisers can fill any gap in clients’ knowledge by sharing both market insights and an in-depth understanding of the different assets that can be included in portfolios.
Self-managed super fund (SMSF) investors are one group that may benefit from such advice. The lack of diversity in their portfolios is reflected in Australian Taxation Office statistics that consistently show SMSFs have a relatively high allocation to cash and shares. As of the end of June 2024, ATO data show the average SMSF has invested 16.4 percent of their capital in cash and 27.9 percent in listed shares[4].
A too conservative asset allocation may prevent individuals from reaching their retirement goals because it may limit their ability to generate significant capital gains over the long term. Those portfolios overweight in shares might encounter issues if their drawdown phase coincides with a market downturn.
In this case study, Levi has an SMSF he manages without professional guidance. He is a conservative investor and over 70 percent of his capital is held in cash and other defensive assets, with just 30 percent in growth assets.
An adviser would instead be likely to recommend that over half his portfolio should be in growth assets given his age, circumstances and objectives. The potential difference in outcomes from the DIY versus advised strategies could make a real difference to Levi’s retirement.
His hypothetical DIY portfolio might return just 4.1 percent over 10 years due to its defensive make-up. A portfolio split equally between growth and defensive investments could generate 5.5 percent and set him up for a better lifestyle.
The significant difference of 1.4 percent is a real indication of the benefits that financial advice and appropriate asset allocation can deliver to investors.
Based on an initial $100,000 balance, after 10 years Levi might have $149,310 in the more conservative portfolio versus a balance of $171,463 for the advised portfolio. In other words, Levi’s DIY strategy could leave him $22,000 worse off after a decade.
Of course, asset allocation isn’t just a set and forget strategy. In periods of steadily rising markets, it can be easy for people to ignore the need to reweight a portfolio and instead let it drift from its initial position. By ensuring portfolios are regularly rebalanced, advisers help clients remain close to their original asset allocations and within their risk comfort zone.
In both case studies, professional advice could help prevent the investors from failing to meet their investment objectives and being in a position to enjoy a comfortable retirement. Actions advisers can take to convey the value of good asset allocation to their clients include:
- Spend time articulating why getting the right asset allocation can be a key driver of achieving goals and the consequences of getting it wrong.
- Remind clients of the art and science of understanding true risk preferences.
- Use your investment philosophy to demonstrate how you select and implement an appropriate asset allocation to achieve clients’ goals.
Appropriate asset allocation is not simply about pursuing the highest possible returns. It involves creating a balanced strategy that effectively manages risk while aligning with your clients’ specific financial goals and time horizons. This approach ensures that investments are tailored to meet the unique needs of each client, whether they are focused on growth, income generation, or capital preservation.
Diversification across various asset classes helps to mitigate the impact of market volatility and reduce exposure to any single risk factor. This diversification not only safeguards against unnecessary risk but also allows portfolios to perform more consistently across different market conditions.
Regular portfolio management and rebalancing play a critical role in maintaining this alignment. Over time, market fluctuations can cause a portfolio’s asset mix to drift from its intended allocation, increasing exposure to risk or diminishing potential returns. By routinely reviewing and rebalancing the portfolio, advisers can restore the desired asset allocation, ensuring the investment strategy remains aligned with the client’s long-term objectives.
Ultimately, a disciplined approach to asset allocation enhances the likelihood of achieving short, medium and longer-term financial goals. It helps clients to navigate the market’s ups and downs with greater confidence, knowing their investments are positioned to maximise returns while staying within acceptable risk parameters. Through a well-executed asset allocation strategy, advisers can deliver a more stable and sustainable path toward financial success and thereby add value to their client relationships.
Asset allocation – the value of advice (part one)
Understanding investor behaviour – the value of advice (part two)
CPD: Adviser expertise – the value of advice (part three)
