Foundations of Financial Economics

The asset allocation decision

Asset allocation - as much art as science …

In the article “Structure explains performance” we argue that the choice of an appropriate asset allocation is the most important decision an investor needs to make. It is a choice about the investment risk you are prepared to take. At the primary level, it is the decision as to how to apportion your investments between:

  • Defensive assets i.e. cash and fixed interest; and
  • Growth assets i.e. Australian and international (including emerging markets) shares and property.

But what are the issues to take into account? We believe that you need to weigh up at least three sometimes competing considerations:

  • Your appetite or attitude to risk – sometimes called your “risk tolerance”;
  • Your need for risk i.e. what level of risk you need to take to give you the best chance of achieving your objectives; and
  • Your capacity for risk i.e.your ability to recover from adverse investment outcomes.

While we attempt to make the examination of each of these issues as transparent and rigorous as possible, the final asset allocation choice turns out to be as much an art as a science. We discuss each of the considerations in more detail below.

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Your attitude to risk …

All things equal, most people prefer lower risk to higher risk and most are risk averse i.e. they require increasing “units” of return to encourage them to take additional “units” of risk.

However, it is very difficult to objectively measure a person’s investment risk tolerance. And even if this could be done reliably, what is the link between this measure and asset allocation choice.

The most scientific approach to tackling both these issues (i.e. objective measure and implications for asset allocation) that we are aware of is provided by Finametrica's Risk Profiling System. Your responses to this 25 question survey provide the basis for the calculation of a “Risk Tolerance Score”, between zero and 100, that can be compared with a very large sample of previous respondents. The survey questions cover the following areas:

  • Making financial decisions;
  • Financial disappointments;
  • Financial past;
  • Investment;
  • Borrowing; and
  • Government Benefits and Tax Advantages.

Respondents are grouped into seven “Risk Groups”, dependent on their risk tolerance scores. The higher the score, the greater the measured risk tolerance.

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The chart below shows the scores and percentages of total respondents allocated to each group. For example, Risk Group 5 recorded risk tolerance scores between 55 and 64 and comprises 24% of all respondents.

The risk profile survey canvases respondents preferred portfolios, return expectations and sensitivity to volatility. The table below shows the alternative portfolios for consideration by respondents. People tend to choose the portfolio number that corresponds to their risk group i.e. respondents allocated to Risk Group 4 tend to choose Portfolio 4:

Expected Return and Risk
High* Medium Low**
Portfolio 1 0% 0% 100%
Portfolio 2

0% 30% 70%
Portfolio 3 10% 40% 50%
Portfolio 4 30% 40% 30%
Portfolio 5 50% 40% 10%
Portfolio 6 70% 30% 0%
Portfolio 7 100% 0% 0%

*Share and property are regarded as high risk

**Cash and fixed interest is regarded as low risk

In principle, your risk profile score enables you to be linked with a portfolio with which you will feel “comfortable”. However, further research by Finametrica reveals that, historically, the portfolio people say they prefer had a return and/or volatility history inconsistent with their expectations (i.e. lower return and/or higher volatility than expected).

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Your need for risk …

An informed assessment of your attitude to investment risk is a major input into the asset allocation decision. However, the expected return from an investment strategy structured solely based on your risk profile score may not be consistent with giving you the best chance of achieving your lifestyle objectives.

Your need for risk is assessed by first examining the extent of any gap between the lifestyle you wish to lead and your expected financial resources available to meet that lifestyle. For a more detailed discussion, see “Our Approach”. If a shortfall exists between lifestyle expectations and financial resources after making all reasonable structural changes to your financial affairs, then the alternatives for closing the gap are to:

  • take more investment risk than initially assumed, to increase the chances of (but not guarantee) achieving your lifestyle objectives; and/or
  • Modify your lifestyle objectives (e.g. work longer, reduce projected expenditure).

The required investment risk of the portfolio most consistent with achievement of your lifestyle objectives may not match the portfolio indicated by your risk profile score. If your need for risk suggests a more risky portfolio this raises an uncomfortable dilemma – do you “eat well or sleep well?” Neither more risk (with uncertain outcomes) nor a lower expected lifestyle is particularly palatable, but conscious, well considered choices need to me made.

Without adequate discussion around these decisions, when growth assets are performing well the tendency is for most people to opt for higher risk than their risk profile indicates they would be comfortable with, rather than pare back lifestyle expectations. However, when the inevitable downturns occur these people often lose discipline and abandon sound financial strategies. Their short term desire for comfort and apparent safety jeopardises their long term lifestyle aspirations.

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Your capacity for risk …

But what if you have adequately resolved any conflicts between your attitude for risk and your need for risk. In our view, you also need to consider your ability or willingness to recover from an adverse investment outcome i.e. your capacity for risk.

For example, what if you have a high tolerance for and a high need for risk, suggesting a high allocation to growth investments. The problem is, you are aged 65, about to retire and are unwilling and/or unable to return to the workforce under almost any circumstances. In this situation, we would regard your capacity for risk as low and encourage you to consider a more defensive asset allocation than that justified by consideration of attitude to and need for risk alone.

An immediate adverse investment outcome at the time of retirement can have disastrous consequences for a growth oriented portfolio (and lifestyle outcomes). The capital losses, together with the need to drawdown on the portfolio for living purposes, may mean that the retiree’s portfolio never recovers despite investment markets subsequently performing strongly. The risk of running out of money with a high growth portfolio is much higher than generally appreciated.

It is often desirable to have a substantial defensive allocation to reduce loss of capital when markets fall, to preserve sufficient funds to benefit from market recovery. Unfortunately, a more defensive portfolio may also require a consequent downward adjustment in lifestyle expectations.

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Weighing up …

Weighing up the three, often competing, drivers of the asset allocation choice is often difficult – something may have to give. But in our view, the asset allocation decision is the most important investment decision you have to make. It is worth a considerable investment of time and effort to ensure it is a smart decision.

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