Ever thought about why street vendors often sell completely random things? Like sunglasses and umbrellas?
It’s an odd combination. You’d think people would rarely need both at the same time.
But that’s the point.
Street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. And when it’s sunny, the reverse is true.
By selling both - or in jargon-speak, “diversifying the product line” - the street vendor can reduce the risk of losing money on any given day.
When it comes to investing, understanding asset allocation is like preparing for rainy conditions, sunny conditions and everything in between.
Diversifying what assets you have allow you to build a portfolio that withstands different environments.
Is the broader economy struggling? Is the market going through a tough time? Do you have unexpected things you need to cover?
Let’s look at the possible asset allocation mixes.
Your situation
Generally speaking, investors look at different categories (referred to as an asset class), such as cash, fixed interest, property and equities (shares).
Determining your asset allocation mix is entirely up to you.
To figure out your mix, you will need to look at factors like your time horizon and your ability to tolerate risk.
Time horizon
This is how long you’ve given yourself to achieve a financial goal. It could be months, years or decades.
If you’ve given yourself a longer time horizon, you might feel more comfortable taking on more risk or a more volatile investment. This is because you can generally wait out long economic cycles and ride out the ups and downs of markets.
If you’ve got a shorter time horizon - let’s say you’d like to save up for a house or a move overseas - you might have a less risky allocation. This helps you avoid getting caught in the inevitable movements in markets.
Risk tolerance
This is your ability and willingness to lose some or all of your original investment, in exchange for greater potential returns.
Someone with a high risk tolerance, is more likely to risk losing more money to get better results.
A low risk tolerance means you're willing to forgo larger potential returns to reduce the risk of losing your original investment.
Understanding risk vs reward
Don’t let anyone tell you otherwise: investing always involves some degree of risk. If you’re looking at buying shares, bonds or into any kind of managed fund (like the ones Spaceship provides) then it’s possible you might lose some or all of your money.
The reward for taking on that kind of risk though, is the potential for a higher investment return. If you’re investing for the long term, you’re likely to make more money by selecting assets with higher risk profiles: like shares. If you can withstand the volatility (that is, prices moving both up and down) you will likely make more money than if you’d invested in something like cash, which has very little risk at all in comparison.
That said, if you have short term goals, like a holiday or a new frock, then cash might be the way to go for your investments!
Investment choices
When you’re looking to build a healthy mix of different investment types, you’ve got quite a few options.
Deep breath (and here are only some of them): shares and share managed funds, corporate and municipal bonds, bond managed funds, lifecycle funds, exchange-traded funds, money market funds, US Treasury securities, and Australian bonds.
But let’s take a look at the three major asset classes.
Shares
Shares are generally considered the riskiest of the three major assets (excluding property), but also historically have come with the higher rewards.
Shares generally offer the greatest potential for growth. Shares can be very volatile and are typically considered a risky investment in the short term.
But investors who have the patience to ride out the volatile returns of shares over long periods of time generally have been rewarded with strong positive returns.
Fixed interest
Fixed interest, such as bonds - which are like buying shares in a government, rather than a company - are generally less volatile but largely return less than shares.
They are useful for when you’re getting close to your financial goal because they reduce the risk of a selloff in the market wiping out some of your gains.
Note: There actually are different types of bonds that offer returns similar to shares, but they are known as high-yield or junk bonds and carry with them higher risk. You can also buy corporate bonds.
Cash
Cash is money sitting as money. “Cash equivalents” are financial products like bank accounts, term deposits, short-term government notes, etc. These are generally the safest investments, lower risk but offer the lowest returns over longer periods of time.
The chances of you losing all your money on a cash investment are generally fairly low, but you generally only return whatever the interest rate is wherever your cash is stored.
The biggest risk for those wanting to invest in cash is that inflation - the price of goods and services raising over time - outpace your interest returns and erode them over time.
Choosing the mix
Historically, shares, bonds and cash haven’t moved up and down at the same time. So generally your best bet is to choose a mix.
This is called ‘diversification’, when you spread money among different investments to reduce risk.
That way, you can limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.
Determining the appropriate asset allocation model for a financial goal is a complicated task. Basically, you're trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with.
At Spaceship, we can’t endorse any particular formula or methodology, but there are some helpful asset allocation calculators that might give you some insight into how to mix your portfolio.
The power of mixing assets means you can decide at any given time what kind of risk you’re comfortable sitting with.
