Investment commentators usually earn their keep by presenting a steady stream of stock and fund ideas. Asset allocation, by contrast, seems dull.

Academic studies, however, have found that asset allocation adds more to portfolio returns than individual stock picking. Put another way, It’s more important in the long term to focus on the portfolio blueprint rather than the nuts and bolts.

In my experience, sound portfolio construction and maintenance are the key to long-term wealth creation – as is knowing when to ‘tilt’ exposures to asset classes as opportunities and risks arise.

This skill separate great investors from the rest. The best active investors – that is, fund managers who have outperformed across multiple cycles – have a knack of knowing when to reduce exposure to assets to preserve capital, and vice versa.

As the rest of us are blinded by fear and greed, great investors take profits during market rallies and put that money back to work when others panic.  This sounds easy in theory but is deceptively hard to do well consistently in practice.

Over the years, I’ve met many investors who don’t think about asset allocation or rebalancing portfolios periodically. Their portfolio is a ‘grab-bag’ of investment ideas and hot tips that work poorly together and increase risk.

Inevitably, they have far too much exposure to a single asset class – Australian equities in the case of Australian share investors – and thus poor diversification. Other investors unwittingly duplicate asset exposures in portfolios.

A simple way to consider asset allocation is through portfolio weightings to cash, equities (local, global and emerging markets), bonds (fixed or floating) and alternatives (such as listed real estate, infrastructure, commodities and private equity and credit).

Investors, of course, can slice up asset allocation in more nuanced ways in portfolio construction. They can also consider currency exposures and different investing styles, such as active and passive investing, in the portfolio.

Or they can take a portfolio core-and-satellite approach with lower-cost index investments in the core that aim to match the market return, and higher-cost active investments as satellites to enhance the portfolio’s total return.

Every investor is different and various stages of life require different asset allocations. An investor in their 30s who has more time to recover from investment mistakes and seeks higher capital growth will have a different asset allocation to a retiree who is focussed on income and capital preservation.

Asset-allocation 101 aside, the end of the calendar year is a good time to think about portfolio construction and rebalancing. For those who have well-designed portfolios, periodic rebalancing – annually is usually enough for long-term retail investors – is a good idea, either at the end of the calendar or financial year.

For clarity, I’m not suggesting wholesale changes, but rather portfolio tweaks through small increases or decreases in asset allocations. It’s a good idea to get financial advice on portfolio changes or do more research of your own before making changes.

For this column, I assume a balanced portfolio. For example, 50% in growth assets such as Australian shares, international shares and emerging markets; 40% in assets such as Australian fixed interest, international fixed income; and 10% cash.

The portfolio might also include 0-10% in alternative assets (though a higher weighting to growth assets and lower weighting to fixed income).

Here are five asset allocation ideas for 2025:

1. Increase cash exposure

Local and global equity market had a cracking rally in late 2024 after Trump won the US election, amid hopes he will boost US and global economic growth.

Although that rally lost some steam in early December, I expect equity markets to climb a little further in January during a usually strong seasonal pattern for equities. That will provide an opportunity to sell into the rally and increase the portfolio cash weighting.

Again, I’m not suggesting big changes. Rather, taking some profits if equity markets rally further in January and a having a bit more cash to put back to work when markets inevitably pull back or correct. High rates on cash (due to elevated interest rates) add to the appeal of a higher portfolio cash weighting.

With markets at or near record highs, investors should focus even more on capital preservation in the first half of 2025. I remain bullish on equity markets in the medium term, (1-3 years), but later in the first quarter of 2025 could be bumpy, particularly if interest rate cuts are yet again delayed in Australia.

2. Decrease Australian equity exposure

The Morningstar Fair Value estimate currently shows the S&P/ASX 200 Index is 11% overvalued, based on valuations for companies it researches. Our equities market has become progressively more expensive since early June.

Australian equities are not excessively overvalued. But an 11% overvaluation in an economy with limp growth, woeful productivity and growing risk requires investors to be alert rather than alarmed.

I argued several times in this column in 2024 that interest rates cuts here will be delayed due to persistent inflation and strong employment. That has been the case, and I still think the first rate cut will be later in 2025 than earlier.

Market disappointment on the timing of local rate cuts – the December 29 quarterly CPI might be the trigger – could spark a pullback. Either way, taking some money off the table in Australian equities in the next month seems prudent as valuations rise.

Chart 1: Morningstar Fair Value Estimate (for S&P/ASX 200 Index)

Source: Morningstar. At 30 November 2024.

3. Increase global equity exposure

The key here is timing. If I’m right, local and international equity markets continue to rally in the New Year, then correct as valuation reality sets in and Trump euphoria fades as we get a closer look at his policies and their effect on inflation.

Having increased portfolio cash exposure (see point 1 above), I’d put that money to work in US and European equities, particularly the banks and commodity producers in mining and energy. I’m wary of emerging markets exposure due to the rally in the Greenback. High debt borrowed in US-dollars has been a historic cause of emerging-market financial crises.

The US and Europe are well ahead of Australian in terms of their rate-cutting cycle, and the US in particularly has strong economic growth prospects under Trump, albeit with heightened volatility and uncertainty.

4. Increase small-cap exposure

 I wrote positively about small-cap exposure several times this year, preferring global small-caps over local ones due to rate cuts in the US and the stronger outlook for its economy over Australia’s economy.

Again, I’d wait for a correction in global equity markets in the first or second quarter of 2024 and put some of that higher cash allocation to work in global small-cap equities. My preferred tool is the iShares Core S&P Small-Cap AUD ETF (ASX: IJR), which tracks US small-cap stocks.

Small-caps globally have underperformed large-caps for several years. An improving US economy should boost US small caps in aggregate due to their leverage to the domestic economy and rising investor risk appetite for growth assets.

Chart 2: iShares Core S&P Small-Cap AUD ETF

 

Source: Google Finance

5. Hedge currency exposure

 I warned readers this year about the risk of a rising Greenback relative to the Australian dollar – a trend that has become more pronounced since September.

Yes, a falling Australian dollar can be a tailwind for local investors with international assets as the value of those assets and income from them increase in AUD terms. But I favour hedging currency exposure – and eliminating currency risk – due to expected heightened volatility in currencies, led by the US dollar.

It’s hard enough to forecast currencies at the best of times, let alone in 2025 if Trump policies lead to more capital returning to the US, and driving the Greenback even higher. If it continues, the rising US dollar could be source of significant volatility later in 2025, particularly in heavily indebted developing nations that rely on commodity exports (priced in US dollars).

Better to avoid all this potential currency volatility and uncertainty through the use of hedged Exchange Traded Funds (ETFs) in portfolios, where available.

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 16 December 2024.