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Understanding Asset Allocation and Risk
Investing can invoke strong emotions in all of us. Even the most seasoned investors worry about market volatility, time in the market and the impact decisions can have on long term plans.
This document contains factual and general information only to assist you in understanding financial planning concepts. It is designed to be used in conjunction with a Statement of Advice.
What is a Risk Profile?
A Risk Profile is a way of finding out a person’s willingness to take on risks.
There are six Risk Profiles, each with their own risk and return characteristics.
Each Risk Profile is linked to investment asset class allocations.
Each Risk Profile is linked to investment asset class allocations.
These Risk Profiles are designed with reference to Morningstar Research, which provides historical and forecast data on risk, returns and asset classes.
How does my adviser use a Risk Profile in their recommendations?
Your Risk Profile is determined by understanding your attitudes to risk and other factors. Once your Risk Profile is agreed, your Financial Adviser will recommend specific investments which reflect the asset allocation and risk characteristics of your Risk Profile.
Focusing on asset allocation
Asset allocation is a way of investing in a mix of investment types or classes such as Cash, Fixed Interest, Shares, Listed Property and Alternatives or Infrastructure. Shares can be further broken down into International and Australian asset classes.
Risk and Return trade off
Investment decisions involve taking risks. In planning to meet your goals, objectives and future needs, you need to consider what level of risk you are willing to take or tolerate to achieve your aims.
What is risk and return?
Return is the reward received for investing. It can be income such as dividends or an increase in value or growth of investments. Risk is the possibility of losing money, real or unrealised. The graph below demonstrates the higher the risk, the higher the potential return.
There are 3 main risks you need to consider:
Inflation: Where inflation or the cost of your lifestyle expenses exceeds the return of your investments. The table below illustrates that a low-risk investment like ‘cash’ with a fluctuating interest rate can be eaten away at by inflation at times. This effectively reduces the purchasing power and ability to fund lifestyle and expenses based on savings alone.
Inflation vs Interest
Investment: Where the performance or return of your investments does not meet the income and or growth expected and potentially you end up with less than when you started (loss of capital). Specific investments may have other risks.
Volatility: Is the ability to ride out fluctuations in the value and performance of investments.
Diversify to reduce risk
Diversification is investing into a mix of different asset classes and even underlying funds, fund styles, companies, industries and economies around the world. Diversification can assist in reducing risk.
The table below shows asset classes in order of best to worst performance since 1994. Green is the best performing year for the asset and red is the worst. History shows you can’t predict with certainty the best performing investment year to year, so don’t try.
Calendar year returns by year and asset class (%)
Time in the Market, not timing the Market
The length of time you wish to invest, your investment time horizon, is critical to improving the probability of meeting your investment goals. You need to consider when you may need to cash in your investment or start to draw an income.
The chart below shows the performance of various asset classes over the last 25 years. As you can see, in the last 25 years, all asset classes have increased over the long term. The chart also illustrates the benefit of diversifying investments across asset classes to help reduce volatility and smooth out returns over time. Blending asset classes over longer time horizons helps reduce risk.
Asset Returns 1990 to 2023
Volatility
Market volatility refers to the movement of the value of investments in the market. Sometimes the values can move rapidly, and this movement can be stressful for investors when they see these values rise and fall quickly. Although market volatility is out of your hands, it can impact on your personal financial situation. There are two types of volatility:
Value Volatility – the value of growth investments fluctuates. This in the short term can be a concern but long term asset values eventually rise as can be seen from the chart. What is important is investing in the right asset class for the length of time you intend to invest to minimise the chance you need to sell down an investment at a low point.
Return Volatility – changes in the return or income received from investments. This is extremely important where you are relying on the income from investments to fund your lifestyle like in retirement.
Risk Profiles
Projected wealth level of $100,000 invested after 10 years (in black band) and the likely range of outcomes (95% confidence interval).
Factual Information Disclaimer
This information has been provided as factual information only. We have not considered your personal financial circumstances, needs or objectives.
Whilst all care has been taken in the preparation of this material, it is based on our understanding of current regulatory requirements and laws at the publication date. As these laws are subject to change you should speak with an authorised adviser or relevant professional for the most up-to-date information. Any case studies, graphs or examples are for illustrative purposes only and are based on specific assumptions and calculations. Past performance is not an indication of future performance.