Why are certain asset classes more appropriate for different types of investors and why no asset class consistently outperforms the others?
Risk vs return
All investments provide a certain level of return and are subject to a certain level of risk. This means that as well as making money on your investments, there’s also the chance you could lose money or not make as much as you expected. All investments carry some risk – due to factors such as inflation, taxation, economic downturns or a drop in a particular market.
As a general rule, the larger the potential investment return, the higher the investment risk and the longer you need to remain invested to reduce that risk. The amount of risk involved with an investment can be managed by matching it appropriately with the length of time you have available to invest and your tolerance towards volatility or fluctuations in returns.
Another way of managing or reducing investment risk is through diversification. This is the strategy of investing your money across a range of different investments. The exact mix of investments you choose will depend on:
- Your financial objectives
- The amount of time you have available to invest
- Your personal tolerance for risk.
Diversification is important because every type of investment has its ups and downs. Owning a diverse range of investments can help you achieve smoother, more consistent investment returns. The more ways you diversify, the more you can reduce your risk. For example, you can invest:
- Across different investment types or asset classes (cash, fixed interest, property, shares)
- In more than one investment within each type (eg invest in several different industries and companies when investing in shares)
- in more than one type of fund, and more than one fund manager, when investing in managed funds
- inside and outside of super.
Dollar cost averaging
By implementing a regular investment plan you will be able to take advantage of ‘dollar cost averaging’. When you invest a set amount at regular intervals, sometimes you will purchase units or shares at a higher price, and sometimes at a lower price. Over time, this spreads out your costs and insulates you against changes in the value of the assets you are purchasing.
The power of compounding
Compounding is often described as ‘earning interest on your interest’. Each time you earn a dividend, distribution or income payment from your investment, you reinvest it to buy more units or shares. In turn, these reinvested earnings generate additional earnings. Compounding can make a huge difference to the value of your investment over time. To take full advantage of the effect of compounding, think about starting early and leaving your money invested for as long as possible.
Which asset classes are best for you?
When we create a financial plan, we use a number of factors to determine which combination of asset classes will work best for you. These factors include your attitude to risk, your investment time frame and your financial and lifestyle goals. The end result or how your money is invested across the different asset classes, is known as your ‘asset allocation’.
For example, if you are a risk-averse investor looking for stable returns or wanting a low-risk, short-term investment option for a sum of money (eg a home deposit) – your adviser would probably weight your asset allocation more heavily towards defensive investments such as cash and fixed interest.
On the other hand, if you are comfortable with short- term fluctuations in the value of your investments and want to invest for more than five years, growth investments such as Australian and international shares may be the best option for you.
If you are concerned that your asset allocation does not match your investment goals or attitude to risk, it’s important to review your financial plan with us. We can adjust your asset allocation as required to help you achieve the best possible results.