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While diversification is clearly important, establishing an optimal investment portfolio requires more than just simply acquiring a wide spread of different assets. To be truly effective, the selection of investments in your portfolio also needs to be tailored to take into account your specific risk profile, financial objectives and investment horizon.
Different asset classes have different risk/return profiles. Shares tend to outperform other asset classes over the long run but their performance can be more volatile. Conversely, bonds generally provide more steady returns but more limited capital growth over the long term. From a global perspective, the fast-growing dynamics of emerging markets (such as Brazil, India) can offer opportunities for strong returns but with more variability than the lower risk, steadier growth opportunities in more developed but stable economies (such as Australia).
The optimal “asset allocation” - or blend of assets - for your portfolio will depend largely upon your profile as an investor. A range of factors, such as your willingness to tolerate risk to achieve investment gains, your financial circumstances, ability to weather losses, your age and the length of time you are prepared to invest, all influence the type of assets which best correspond to your specific profile and objectives. For example, individuals with longer investment horizons and a willingness to endure some volatility in returns will generally be suited to portfolios which are weighted more heavily towards shares and property. Older investors with a higher need to avoid capital losses might be better suited to a portfolio weighted towards bonds and cash.
As it turns out, there isn’t just one optimal portfolio – but rather a series of optimal portfolios. In fact, for every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be represented graphically on a risk/return graph- and the resulting curve is known as the “Efficient Frontier”. Portfolios lying on the “Efficient Frontier” represent the best possible combination of expected return/risk. An investor’s position on the frontier will be determined by the maximum level of risk that he/she is willing to take on.
At Six Park, our team use a sophisticated evaluation and assessment process to matches your risk profile with a recommended asset allocation strategy. Your recommended allocation will comprise a mix of up to six different asset classes – namely Australian shares, international shares, emerging market shares, listed property, bond/fixed income and high interest cash deposits – in proportions that are adapted to reflect your own risk profile, investment goals and the current investing environment.
Finding an optimal portfolio for our investors requires (amongst other things) a technique known as “mean-variance optimization”. This is a complicated number crunching exercise which analyses the way in which individual asset classes perform (i.e. how much they return – and how volatile those returns are) and how that performance compares to other asset classes (i.e. how closely correlated are their performances). Using this information, it is possible to blend different asset classes (especially those which tend to move in opposite directions to one another) to maximize performance whilst also reducing overall risk. We use this technique as the foundation for determining the allocation of asset classes across each of our portfolios.