FFS TRANSLATE: What’s asset allocation?

Asset allocation refers to diversifying your investments into different categories with different risk levels.  An asset can be anything from your home to your right to collect royalties on a book that you wrote¹. But when people describe asset allocation, they’re usually talking about money that you invest in the stock market or in your superannuation fund.  This money is invested in three main ways:

1. You buy companies. When you buy a share, you’re buying equity. When you buy BHP Billiton shares, you become a part-owner of the company. You have equity in BHP Billiton.

If you don’t want to buy shares directly, you can buy a fund that holds shares in several different companies. Index funds, for example, are collections of lots of different types of shares, bundled together in one basket.

Different shares have different levels of risk; however, they are generally accepted to be higher risk than fixed-interest or cash.

2. You give loans. When you buy a bond, you’re giving out a loan to whatever group issued (asked for) that bond. If you buy a corporate bond, you’re giving a corporation (company) a loan.  If you buy a government bond, you’re giving the government a loan.  The company or government must pay you interest on that loan. It has a “payment plan” on a fixed timeline. For example, it might pay you interest once a month, or once every three months.

That’s why this is called a “fixed-income” investment: you get income on a fixed schedule.

Government bonds are considered incredibly low risk because the risk of the government not paying you, or going “bankrupt”, is incredibly low.

3. Or you keep it in cash. Self explanatory.

Asset allocation means that you spread your money between a combination of these three categories: equities, fixed-income and cash.  There are several common “combinations” of these categories that you may have heard of:

We will consider several factors when developing an asset allocation that’s appropriate for you, including:

• Investment goals. We will need to understand your short and long-term objectives – buying a house, private education for your children, impending retirement, or financing a business – to create an asset allocation that helps you reach your goals.

• Risk tolerance. Do you lose sleep when the markets fall? Or do you shrug off market volatility and wait for it to recover? We will help you to understand your emotional reactions to the risks of investing and can help you create a plan that suits your investment temperament.

• Timeframe. To tailor your portfolio to your goals, it’s important to define your investment timeframe. A portfolio invested to fund your retirement in 20 years would include a different selection of shares than a portfolio intended to finance retirement tomorrow. For example, a someone who wants to grow their super account might be willing to tolerate short-term price fluctuations in the share market. On the other hand, if you want to retire next year, you might be more likely to choose an allocation that’s more suitable for generating income. We will work closely with you to establish an allocation to meet your needs.
• Comfort with risk versus return. Risk and return are closely related. The concept of risk/return suggests that low levels of investment risk will result in low returns, while high levels of risk will generate higher returns. Of course, there are no guarantees. While increased risk offers the possibility of higher returns, it also can lead to bigger losses. Balancing the risk you are willing to accept with the investment returns you need or want is something we will discuss with you. The diagram below is a simple illustration of the relationship between risk and return.