When creating a strategy that determines the best possible asset allocation, both objectives and time horizon should be considered.
Ideally, all investors should have an objective they aim to achieve with their investments. These objectives should be tied with a preferred time horizon—the amount of time an investment is held or the period between when the assets were purchased and when the portfolio will be liquidated.
For instance, a 30-year-old who plans to retire when they reach 65 years may build an investment portfolio with a larger allocation for growth assets than low-risk debt securities. As their time horizon decreases, their portfolio should start to shift and carry more low-risk assets, such as government bonds.
Once they determine their goals and time horizon, investors need to allocate a diversified set of assets to their portfolio.
How to diversify
Some beginner investors may simply think that diversification means buying different types of investments, but there are other things to consider when properly structuring an investment portfolio.
Diversification can be a simple process if an investor considers doing the following:
- Invest in different asset classes
- Consider different markets and sectors
- Schedule different maturities along the time horizon
Invest in different asset classes
Investors automatically think of shares, bonds and properties when building their portfolio, but there is actually a large variety of investment products available that belong to different asset classes.
Investors should at least consider allocating their capital to these four asset classes:
Cash: These refer to cash-based investments such as savings accounts, certificates of deposit (CDs), checking accounts and money market funds.
Investors may allocate more capital as cash if their investment horizon is very short and if they cannot risk losing their principal investment.
Fixed interest or debt securities: These refer to ‘low-risk’ investments that yield regular returns until its maturity, such as bonds.
This asset class is more exposed to volatility than cash-based investments, but there is also a better assurance for income generation.
Equities: Equities usually refer to shares. It involves shareholders becoming part-owner of the underlying business. Depending on the type of share, shareholders can receive regular income in the form of dividends or they may rely solely on the underlying asset’s increase in value. Equities may also come in the form of managed funds that takes other equities as its underlying assets.
Despite being the best defence against inflation, equities are exposed to various market risks and can change in value multiple times in a single day. This means equities may not be the best choice for investors with a short time horizon.
Property: This may refer to physical bricks and mortar real estate structures and may be held directly or indirectly. Owners are responsible for the daily operations of direct property investments, while investors using indirect investments only invests money in exchange for income from the managed property.
Direct properties are safe from market volatility but its value may still depreciate if the real estate market dips in the area where the structure is built.
Consider different markets and sectors
Once the investor has decided on the asset class allocation based on their objectives and time horizon, they may further diversify the portfolio by selecting assets from different markets and sectors.
For instance, a portfolio with an allocation of 10 per cent cash, 30 per cent fixed income and 60 per cent equities may be further divided. The fixed income portion may be composed of 60 per cent government bonds and 40 per cent corporate bonds. Equities may be divided into 40 per cent blue chips, 30 per cent individual stocks in emerging markets, renewable energy and local food sector and 30 per cent in listed property funds.
The example above cover different industries and increases the portfolio’s potential for high growth by extending its reach to foreign markets.
Schedule different maturities along the time horizon
Another way to diversify an investment portfolio is to limit the timing risk by spreading out the purchase and liquidation of assets.
This may be done by following a disciplined strategy like dollar cost averaging, which helps investors reduce the impact of price volatility over time.
They may also use a similar technique to bond laddering, which requires investors to invest in bonds with different maturities, then reinvesting the income generated from a mature bond to the next maturing bond.
Diversification is only the beginning
A well-diversified portfolio is a stable portfolio that weathers market downturns, preserves capital and minimises loss; however, investors must remember to check their portfolio at least annually and rebalance as necessary—especially if objectives change.
As the underlying investments increases in value, the allocation tends to become skewed in favour of assets that have appreciated in value.
It is recommended for inexperienced investors to seek the advice of licensed professionals to better plan their portfolio.
This information has been sourced from the Australian Investors Association and Nest Egg.