Why asset allocation matters

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By Maria Smit, CFP®* 

The importance of an appropriate asset allocation plan has been highlighted by the recent volatility in global financial markets.

The variability of returns in the various asset classes from year to year is a key reason as to why investors should diversify investments across all the asset classes. As no-one is sure what future investment returns are going to be for any of the asset classes, the best way to capture future returns is to spread investments across different asset classes.

Maria Smit

A financial planner should assist you in determining the return that is required on your investments and access the asset allocation necessary to achieve this return over the longer term. It also is vital to consider the risk tolerance of an investor at this stage.

Diversification is the best form of reducing the risks inherent to long-term investing. Research from Vanguard has found that over time, asset allocation dictates over 80% of portfolio returns, which means it is far more important for investors’ personal portfolios to be spread across a variety of investment classes, ranging from the more traditional spectrum of shares, property, cash and bonds to the alternative options such as hedge funds and private equity.

When structuring allocations to the various asset classes (equity, property, bonds and cash) and the selection of local versus offshore, it is first important to understand what your investment objectives are. It is also important to understand your investment time horizon as well as the investment return you are aiming to achieve over that period. This will provide guidance on an appropriate weighting in respect of the various asset classes.

The primary objective of investing is to achieve above-inflation returns to ensure that you receive real growth on your investments. Inflation has the effect of decreasing one’s purchasing power over time. For instance, you could buy more with R20,000 in 2010 than in 2021. As such, asset classes can be separated into growth and inflation-matching (or defensive) sections.

The objective of growth assets is to achieve long-term outperformance of inflation to keep investments increasing in value in real terms.

Determining how to better allocate assets is relative to the investor’s objectives and investment timeline. If investing for the long term, as for retirement or financial independence, then a larger allocation of growth assets would be more appropriate. Short-term market volatility should be overlooked, and the focus should rather be on long-term inflation-beating returns.

If your needs are more immediate, such as a deposit on a vehicle or property, then it would be advisable to have a greater share in the defensive assets classes to protect your funds from short-term market volatility.

For example, last year the JSE experienced a large and sudden drop. due to uncertainty around the coronavirus outbreak. The JSE did recover towards the end of 2020 but its performance for the past five years is well below that of several global markets.

If you had been in the process of buying property at the beginning of March 2020, your cash deposit would be worth significantly less as a result of this sharp decline. On the other hand, if you are a long-term investor, this same decline in the markets could create an opportunity to buy good quality but undervalued assets for the longer term.

Over the last one, five and ten years, the best performing asset classes in South Africa have been the bond market, while equities have barely kept pace with inflation.

It is therefore important to focus on the fundamentals of asset allocation over the appropriate time frames.

With this in mind, it is key to first identify and understand your investment objectives with respect to timeline and returns. Once you have clarity on these matters, you will be able to undertake strategic asset allocation to align your portfolio with your goals.

Also ensure your total lifestyle allocation is in line with your risk level. For example. If you get closer to retirement it is important to have liquidity in your asset allocation. You cannot have just a house and a living annuity. If your car breaks you cannot buy a car with a loan when you are 70. Banks do not want to take on so much risk giving loans to people over a certain age. Therefore, liquidity is important to your asset allocation.

It is important to note that all your assets should be considered when looking at your asset allocation. Your house would count as local property. Money in the bank should be seen as a local money market. But here is a breakdown of available asset classes as prescribed by regulation 28 of the Pension Funds Act.

Local Equity: Shares in South African companies that are listed on the JSE.

Local Property: Also referred to as listed property. Local property includes both property management companies and property unit trusts that are listed on the JSE.

Local Fixed Interest: These are investments that yield a regular return. The most common examples of these are corporate or government bonds. Bonds are a form of debt that is issued when the issuer (borrower) needs to raise capital. Repayment is specified at a predetermined interest rate and date.

Local Money Market: Fixed interest investments that aim to offer investors better interest rates than a savings account at a bank. They offer a regular interest income and capital stability, but minimal capital growth.

Foreign Equity: Equities are also referred to as shares or stocks. Foreign equity refers to shares in companies that are listed on a stock exchange in a country other than South Africa; for example, the New York Stock Exchange (NYSE).

Foreign Other: This refers to: foreign money markets, which offer exposure to foreign currencies such as the US dollar or the British pound; foreign fixed interest, which refers to investments such as bonds issued by non-South African governments and companies.

Read more about investment planning.

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