Learning Objectives

After completing this chapter, you will be able to:

• Understand what asset allocation is.
• Learn the difference between growth and defensive assets.
• Understand how investment goals influence asset allocation.
• Learn why time horizon is important when investing.
• Understand how risk tolerance affects investment decisions.
• Build a foundation for creating a balanced investment portfolio.

Introduction

Choosing the right investments is important, but deciding how much to invest in each type of asset is even more important. This process is known as asset allocation. A well-planned asset allocation can help manage risk, improve diversification, and support long-term financial goals.

What is Asset Allocation?

Asset allocation is the process of dividing your investments across different types of assets.

Rather than investing all your money in one investment, asset allocation spreads your investments to help balance risk and potential returns.

Common asset classes include:

• Australian Shares
• International Shares
• Exchange Traded Funds (ETFs)
• Property (REITs)
• Bonds
• Cash

Every investor's asset allocation will be different depending on their financial goals and personal circumstances.

Why is Asset Allocation Important?

A suitable asset allocation can help investors:

• Reduce investment risk.
• Improve diversification.
• Balance growth and stability.
• Manage market volatility.
• Stay focused on long-term financial goals.

Many investment professionals believe that asset allocation has a significant influence on long-term portfolio performance.

Growth vs Defensive Assets

Investments are often grouped into two broad categories:

• Growth Assets
• Defensive Assets

Understanding the difference helps investors build portfolios that suit their objectives.

Growth Assets

Growth assets aim to increase in value over the long term.

Although they may experience greater short-term price fluctuations, they generally offer higher long-term return potential.

Examples include:

• Australian shares.
• International shares.
• Growth-focused ETFs.
• Listed property investments (REITs).

Characteristics of Growth Assets

• Higher return potential.
• Higher short-term volatility.
• Suitable for long-term investors.
• Capital growth is the primary objective.

Defensive Assets

Defensive assets focus on preserving capital and providing more stable returns.

They generally experience lower volatility than growth assets but may also provide lower long-term returns.

Examples include:

• Cash.
• Savings accounts.
• Government bonds.
• High-quality fixed-income investments.

Characteristics of Defensive Assets

• Lower investment risk.
• More stable returns.
• Lower expected long-term growth.
• Useful during periods of market uncertainty.

Growth Assets vs Defensive Assets

Most investors include both types of assets within their portfolios.

Allocating Investments Based on Goals

Your investment goals play a major role in determining your asset allocation.

Examples of investment goals include:

• Building long-term wealth.
• Saving for retirement.
• Buying a home.
• Generating regular income.
• Preserving capital.

Different goals often require different investment strategies.

Example

An investor saving for retirement in 30 years may allocate a larger portion of their portfolio to growth assets.

An investor planning to purchase a home within two years may choose a higher allocation to defensive assets to reduce short-term risk.

Understanding Time Horizon

Your time horizon is the length of time you expect to remain invested before needing your money.

Generally:

Long Time Horizon

• 10 years or more.
• Greater ability to recover from market downturns.
• May allow for a higher allocation to growth assets.

Medium Time Horizon

• Around 5 to 10 years.
• Balanced mix of growth and defensive assets may be appropriate.

Short Time Horizon

• Less than 5 years.
• Investors often prioritise stability over growth.
• Higher allocation to defensive assets may help reduce short-term risk.

Every investor's circumstances are different, and there is no single asset allocation that suits everyone.

Understanding Risk Tolerance

Risk tolerance refers to the level of investment risk an individual is comfortable accepting.

Risk tolerance varies from person to person.

Factors that influence risk tolerance include:

• Age.
• Financial goals.
• Income.
• Investment experience.
• Time horizon.
• Personal comfort with market fluctuations.

Understanding your own risk tolerance helps you choose investments that align with your financial objectives.

Example Asset Allocations

The following examples are for educational purposes only and are not investment recommendations.

Actual asset allocations should reflect an individual's financial goals, circumstances, and risk tolerance.

Reading a Real ASX Example

Let's consider two investors.

Investor A

• Age: 28
• Goal: Retirement in 35 years

This investor may choose a higher allocation to:

• Australian Shares
• International Shares
• Growth ETFs

because they have a long investment time horizon.

Investor B

• Age: 60
• Goal: Generate regular income and preserve capital

This investor may choose a larger allocation to:

Bonds

• Cash
• Income-producing investments
• Dividend-paying shares

because capital preservation and stability may become more important as retirement approaches.

These examples demonstrate how asset allocation can differ based on individual goals rather than following a single approach.

Why Asset Allocation Matters

Asset allocation helps investors answer important questions such as:

• How much risk am I comfortable taking?
• What are my financial goals?
• When will I need my money?
• Should I focus more on growth or stability?
• Is my portfolio well diversified?

A thoughtful asset allocation strategy provides a strong foundation for long-term investing.

Key Takeaways

• Asset allocation is the process of spreading investments across different asset classes.
• Growth assets offer higher potential returns but generally involve higher risk.
• Defensive assets focus on preserving capital and providing greater stability.
• Investment goals influence how assets are allocated.
• Time horizon plays an important role in determining suitable investments.
• Risk tolerance differs for every investor and should be considered before investing.
• A diversified asset allocation can help manage investment risk over the long term.