At the heart of any investment strategy is asset allocation – knowing what investments are available, and how they should be combined so as to produce the stronger long-run returns for acceptable levels of risk.

Investors could buy any number of exotic investments – from rare stamps to fine wine. But here, let’s confine ourselves to the five basic investments covering cash, bonds, property, equities and commodities. An example of an investment portfolio diversified across major asset classes using cheap exchange-traded funds (ETFs) is provided in my earlier articles: How to create a balanced fund with ETFs.

Let’s examine how these asset classes might be combined for investments through different stages of your investment life-cycle, looking at examples for someone in their 40s, 50s and 60s.

Set your risk

The basic rule of portfolio construction is that (typically younger) investors with a longer investment time horizon should seek to take on more risk – in the form of accepting greater year-to-year volatility in portfolios returns.

Although volatility is never comfortable, those with a longer investment horizon know they have more time to recoup any short-run losses because markets tend to move in cycles. As a result, they should exploit this advantage and add risk in order to get a higher long-run return.

Those closer to retirement, however, are less able to accept a large short-run loss on their portfolio (as they will need to live off it sooner) and so should better protect themselves by having a higher share of their portfolio in less volatile investments.

Within our asset classes, cash offers the lowest volatility in returns, but also the lowest long-run expected return (around 5%). Bonds offer a slightly higher return (around 5.5 to 6.5%), but with moderately greater volatility. Equities offer the highest long-run returns (which for Australian equities should be around 8.5 to 10%), but with largest return volatility.

Over recent decades, for example, the standard deviation in Australian equity returns has been just under 20% – meaning there’s around a 15% chance of losing more than 10% in any given year. In 2008, the loss was closer to 40%, with the market rebounding 40% the following year!

Spice it up

We can also spice up the portfolio mix through the addition of international bonds and equities, along with commodities. While these don’t necessarily offer higher returns, they have the advantage of adding diversification – meaning we can achieve higher overall portfolio returns for the same level of risk.

Based on historical performance and correlations over recent decades, some estimates of likely risk and returns by asset class are provided below.

Asset class assumptions

Several points are worth noting. For starters, bonds have the added advantage of their returns generally being negatively correlated with the return from equities – that is, when the economy is weak and equity prices are falling, interest rates tend to fall also, which boosts the returns from bonds.

Note also that property and international equities are positively correlated with the Australian share market, but it’s less than a perfect relationship – so they offer some modest diversification benefits.

Gold also offers low correlation with the Australian market, but assuming its real value is broadly constant over the long run, its returns might not be more than inflation.

Of course, opinions over likely long-run returns will differ among investors, and return volatility and correlations can shift around over time depending on the nature of economic shocks. But to my mind, these are reasonable working assumptions for setting up a core (or strategic) asset allocation.

Asset allocation by risk

Let’s now assume someone in their 40s (being younger) wants a high-risk portfolio, someone in their 50s a medium-risk portfolio, and someone in their 60s, a low-risk portfolio.

If we crank through a portfolio optimisation, these assumptions suggest an investor wanting a low risk portfolio (such that the probability of a negative return year was less than 10%) should have around 80% of their portfolio in cash or bonds, and 20% in (mainly Australian) equities. Those seeking medium-term risk, would tilt their portfolio with 60% in bonds and 40% in equities. A higher risk portfolio would have most risk (naturally enough) in equities.

Of course, if you’re relatively young, but still feel anxious about portfolio volatility, you might want to beef up your cash/bond allocations relatively more compared to that suggested.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.