At the time of writing the United States market was down about 4 per cent for the week, while the Australian market has had a drop of about 2.50pc. This period of market volatility seems to be focused on renewed worries about the trade war between the US and China as well as rising global yields and the outlook for the global economy.
During periods of market volatility we remind our clients of the importance of using asset allocation. In fact, asset allocation explains about 90pc of the variability in returns over an investor’s lifetime, so deciding on the mix of assets in your portfolio is probably the most important investment decision you’ll ever make.
The essence of asset allocation is diversification. By spreading your investments across different types of securities you not only reduce the risk of your portfolio losing money; you also increase the chance that it will make money. Of course no matter what asset allocation you choose, there’s no way to eliminate risk entirely.
Income vs growth assets
Mainstream asset classes can be grouped into income assets (cash and fixed interest) and growth assets (shares and property).
Income assets tend to be conservative, low risk assets such as bank accounts and term deposits. They usually pay investors a specified income on a regular basis. The trade-off for the lower risk is that the expected return from income assets is usually less than that from growth assets.
Growth assets are riskier, as the capital value can rise or fall dramatically over the short term. That said, over long periods of time growth assets are expected to outperform income assets, and thus a large allocation to growth is essential for investors looking to accumulate wealth.
How much should you allocate to shares?
The right mix of income and growth assets will vary from person to person, depending on your individual needs and circumstances. As a general rule, your allocation to shares should be higher if you have a long term outlook, as shares are more likely to outperform fixed interest in the long term.
Investors with a shorter time horizon should focus on cash and fixed interest, as holding shares for short periods can be very risky.
Retirees would also place more emphasis on holding income assets within their superannuation portfolio to help maintain pension payments. However, some exposure to growth assets is important as well, as the portfolio needs to continue growing to ensure longevity.
What does the future hold?
It is vital investors expect returns that are in line with economic realities. Growth assets tend to outperform when economic growth is strong and interest rates are low, while income assets do well when growth is slowing and rates are rising. Investors should focus on finding an asset allocation that suits their investment needs and is more likely to do reasonably well under a wide range of market conditions. Investors should also avoid 'knee jerk' reactions when short-term market issues do arise, and keep long term investment plans in perspective.
As markets mature, it is not uncommon for volatility to increase as investors become worried and begin to think “is this the beginning of the end?”. That being said, as we have discussed in the past volatility is required as this is ultimately what allows greater returns to be derived from investments compared to cash based securities.
During periods of volatility such as that which has occurred recently our recommendation would be to avoid making decisions on emotion. In situations where it is applicable, this could also represent a buying opportunity.
- Boh Burima Financial Adviser (Authorised Representative: 000341081) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410